SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    Form 10-K

(Mark One)
 [X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934
      For the fiscal year ended December 31, 1997

                                       OR

 [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE  ACT OF 1934 [NO FEE REQUIRED]
      For the transition period ________ to ________

      Commission File Number 1-12368

                            THE LEATHER FACTORY, INC.
             (Exact name of registrant as specified in its charter)

           Delaware                                         75-2543540
(State or other jurisdiction of                          (I.R.S. Employer
 incorporation or organization)                           Identification Number)

   3847 East Loop 820 South
     Fort Worth, Texas                                          76119
(Address of principal executive offices)                     (Zip Code)


       Registrant's telephone number, including area code: (817) 496-4414

           Securities registered pursuant to Section 12(b) of the Act:

    Title of Each Class                Name of Each Exchange on Which Registered
    -------------------                -----------------------------------------
Common Stock, par value $.0024                 American Stock Exchange

           Securities registered pursuant to Section 12(g) of the Act:

                                      NONE

     Indicate  by check mark  whether the  registrant  (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

     Indicate by check mark if disclosure of delinquent  filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

     The aggregate  market value of the common stock held by  non-affiliates  of
the  registrant  was  approximately  $1,435,034  at March 18, 1998. At that date
there were 9,853,161 shares of Common Stock outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE

     Certain  portions of the  Registrant's  definitive  Proxy Statement for the
Annual Meeting of  Stockholders  to be held on May 21, 1998 are  incorporated by
reference in Part III of this report.


<PAGE>


                                     PART I

Item I.  Business.

General Development of Business

     The Leather Factory,  Inc. ("TLF" or the "Company") was incorporated  under
the laws of the State of Colorado in 1984 and  reincorporated  under the laws of
the State of Delaware in June 1994.  TLF is the  successor  to several  entities
that were parties to a merger  transaction  in July 1993.  One of these entities
involves a business that was  incorporated  pursuant to the laws of the State of
Texas in 1980. The Company's principal offices are located at 3847 East Loop 820
South, Fort Worth, Texas 76119 and its phone number is 817/496-4414.

     Refinancing.  On November  21,  1997,  the Company  entered into a Loan and
Security  Agreement with FINOVA  Capital  Corporation  ("FINOVA"),  according to
which FINOVA  agreed to provide a credit  facility of up to $9,136,000 in senior
debt (the "Senior Debt Facility").  The Senior Debt Facility has a two-year term
and is  secured  by all of the  assets  of the  Company  as well as a pledge  of
3,000,000  shares of the  Company's  common  stock,  par value  $.0024  ("Common
Stock"),  collectively  owned  by  two  of  the  Company's  executive  officers.
Simultaneously,   the  Company   also  issued  at  face  value  its   $1,000,000
subordinated  promissory  note to The Schlinger  Foundation  (the  "Subordinated
Debenture").  The  Subordinated  Debenture  also has a two-year  maturity and is
partially  secured by a pledge of 2,666,666 shares of the Company's common stock
owned by another executive officer.

     Proceeds of these  financings were used to pay all amounts due and owing by
the  Company  to  NationsBank  of Texas,  N.A.  ("NationsBank").  The  Company's
revolving  line of  credit  and  term  loan  facility  with  NationsBank  in the
principal amounts of $5,125,000 and $2,200,000,  respectively, were satisfied in
their  entirety.  The Company had been in continuing  default under the terms of
its financing arrangements with NationsBank since June 30, 1996 and had operated
pursuant to the provisions of certain forbearance  agreements by and between the
Company and  NationsBank  since that date.  The default  involved the  Company's
violation  of  covenants  dealing  solely  with  the  failure  to  meet  certain
prescribed  financial ratios. The Company at no time failed to make a payment of
principal or interest on its indebtedness to NationsBank.

     The Company used the remaining proceeds to pay financing costs. The Company
is currently in compliance  with all covenants and  conditions  contained in the
Senior Debt Facility and the Subordinated Debenture and has no reason to believe
that it will not continue to operate in compliance  with the provisions of these
financing  arrangements.  The principal  terms and conditions of the Senior Debt
Facility and the Subordinated  Debenture are described below, see  "Management's
Discussion  and Analysis of  Financial  Conditions  and Results of  Operations -
Capital  Resources  and  Liquidity"  and  Note 3 to the  Consolidated  Financial
Statements.

     Improved Operating Results. The Company significantly  improved its results
from  operations  during the current  year.  Net income  improved from a loss of
$989,768 for the year ended  December 31, 1996, to net income of $70,292 for the
1997 year.  In its plan to return to  profitability,  the  Company  focused  its
attention  during 1997 on improving gross profit margins and lowering  operating
expenses.  Gross profit as a percentage  of sales  increased  from 37.4% for the
year ended December 31, 1996 to 41.6% for the current year. Operating costs as a
percentage  of sales fell 1.6  percentage  points or $1,503,686 in actual dollar
terms  during  the 1997 year  compared  to 1996,  due to cost  control  measures
instituted by management during the latter part of 1996 and in the current year.
Some of the gross profit increases and operating expense  reductions came at the
expense of lower  sales,  which  decreased  $2,854,516  or 10.1% during the year
ended  December  31,  1997  from  the  amounts   generated  in  1996.  See  also
"Management's  Discussion  and Analysis of Financial  Conditions  and Results of
Operations  -  General;  - Costs,  Gross  Profit,  and  Expenses;  and - Capital
Resources and Liquidity."

     Opening of New  Sales/Distribution  Units and Acquisitions.  In a departure
from the last several  years,  due to the  financial  constraints  involved with
operating  under  forbearance   arrangements   with  NationsBank,   as  well  as
management's focus on improving the results of existing operations,  the Company
did not  close an  acquisition  or open a new  location  during  the year  ended
December 31, 1997. Subject to remaining in compliance with the provisions of the
Senior Debt Facility and the Subordinated Debenture,  and management's desire to
achieve  even  greater  improvements  in existing  operations,  the Company will
resume its expansion plans.  See also "-Expansion and Acquisition  Strategy" and
"Management's  Discussion  and Analysis of Financial  Conditions  and Results of
Operations - General; - Capital Resources and Liquidity."

     New Computer  System.  The Company  installed a new computer  system in its
central warehouse and largest  sales/distribution unit. This new system has also
been  installed in the Company's  accounting  department.  The Company is in the
process of implementing  the new system to achieve  point-of-sale  and perpetual
inventory  capabilities  as  well  as to  obtain  certain  sales  and  financial
information more rapidly.  Once the system is fully operational in the Company's
central  locations  in Fort  Worth,  Texas,  the  new  computer  system  will be
installed and  implemented in phases in the Company's  other  sales/distribution
units.

                                       2


<PAGE>


Narrative Description of Business

     Background.  TLF  operates  in one  industry  segment  as an  international
wholesale  manufacturer  and  distributor of a broad product line which includes
leather,  leatherworking  tools, buckles and other belt supplies,  shoe care and
repair  supplies,  leather dyes and finishes,  adornments  for belts,  bags, and
garments,  saddle and tack  hardware,  and  do-it-yourself  kits.  The  Company,
through its subsidiary,  Roberts,  Cushman & Company, Inc.  ("Cushman"),  in New
York,  New York,  produces a related  product  line  involving  hat  trims,  the
decorative  piece of  material  that  adorns  the  outside  of a hat,  and small
finished leather goods such as cigar cases, wallets and western accessories. The
Company frequently  introduces new products either through its own manufacturing
capability or through  purchasing from vendors.  The Company holds a substantial
number of  copyrights  for its designs.  These  designs  have been  incorporated
throughout the Company's  product line as a means of increasing its  competitive
advantage.

     The Company's customer base is comprised of over 40,000 customers including
retailers,  wholesalers,   assemblers,  distributors,  and  other  manufacturers
dispersed  geographically  throughout  the world.  The majority of the Company's
customers are  wholesalers.  TLF sells  inventory  ranging from raw materials to
finished goods.

     The  Company  manufactures  some of its own  products,  but also  purchases
products from other  manufacturers and distributors in fourteen  countries.  The
Company  has light  manufacturing  facilities  in Fort  Worth,  Texas,  where it
produces  items  such  as  suede  lace,   garment   fringe,   leathercraft   and
craft-related  kits,  and in New York,  New York,  where,  through  its  Cushman
subsidiary,  it produces hat trims and small finished  leather  goods,  as noted
above.

     The Company  distributes its products through 21  sales/distribution  units
located in  seventeen  states and one located in Canada  plus its  manufacturing
facility  and  show  room  in  New  York.   The   geographic   location  of  its
sales/distribution  units is selected based on the location of its customers, so
that delivery time to customers is minimized. A two-day maximum delivery time is
the Company's goal. In addition to offering its customers  rapid  delivery,  the
Company  also  offers  a  "one-stop  shopping"  concept  for  both  leather  and
leathercraft materials.

     Corporate  History.  The Company is the successor to certain  entities that
were parties to a series of  transactions  including a merger in July 1993 which
involved The Leather  Factory,  Inc.,  a Texas  corporation  ("TLF-Texas"),  and
National Transfer & Register Corp. ("National"),  a Colorado corporation,  which
had no operations  and whose capital stock had no active trading market prior to
the merger.  The surviving entity changed its name to The Leather Factory,  Inc.
and its business became that conducted by TLF-Texas.  National was  incorporated
under the laws of Colorado in 1984 and  conducted  business as a stock  transfer
agency from January 1985 to April 1993. In June of 1993, the principal  officers
and directors of TLF-Texas, Wray Thompson, Ronald C. Morgan and Robin L. Morgan,
acquired shares of National Common Stock and were elected to National's Board of
Directors.

     In July of 1993,  pursuant to a reverse merger  agreement  among  National,
TLF-Texas,  and the  shareholders  of  TLF-Texas,  National  acquired all of the
outstanding  Common Stock of TLF-Texas  in exchange for  7,805,478  newly issued
shares of National Common Stock. In connection with this  transaction,  National
effected a 1 for 24 reverse  stock  split.  The name of National  was changed to
"The Leather Factory,  Inc.",  and National's  business became that conducted by
TLF-Texas.  Any reference to "Company" herein includes,  where  applicable,  the
activities of TLF-Texas after the acquisition of TLF-Texas by National.

     TLF-Texas was initially  incorporated  under the laws of Texas in 1980 with
the name Midas Leathercraft Tool Company ("Midas").  Originally, the business of
Midas involved the distribution of certain leathercraft tools. After the reverse
merger transaction with National,  the Company in June of 1994 reincorporated in
Delaware. As part of its strategy to develop a multi-location chain of wholesale
units the  Company  has made  numerous  acquisitions  since  its  incorporation,
including  the purchase of six wholesale  units from Brown Group,  Inc., a major
footwear  retailer.  The Company has also acquired  several  businesses  located
throughout the United States that distribute  shoe-related  supplies to the shoe
repair and shoe store industry.  In addition,  the Company  purchased Cushman in
1995, a leading  producer of hat trims.  In March of 1996, the Company  acquired
all of the issued and outstanding capital stock of its Canadian distributor, The
Leather Factory of Canada.

     Business  Concept.  Wray  Thompson  and  Ronald C.  Morgan,  the  Company's
founders,  conceived "The Leather  Factory  Concept." This concept  includes the
geographical   location   and   type  of   space   rented   for  the   Company's
sales/distribution units, the size and configuration of the units, the number of
items comprising the merchandise line, the utilization of direct mail, including
the use of an annual full-line catalog, and the application of rapid delivery to
customers.

                                       3

<PAGE>


     The Company's 22 sales/distribution units combine the economies of scale of
warehouse locations with the marketing efficiencies that can be achieved through
direct mail.  Walk-in  traffic and mail order  customers  are served in the same
location.  The  type  of  premises  utilized  for  the  sales/distribution  unit
locations is generally light industrial office/warehouse space in proximity to a
major  freeway or with  relatively  easy access  thereto.  This kind of location
typically  provides lower rental expense  compared to other more retail oriented
locations.  The size  and  configuration  of the  sales/distribution  units  are
carefully  planned to allow large  quantities  of product to be  displayed in an
easily  accessible and visually  appealing  manner.  Leather is displayed by the
pallet  where  the  customer  can see and  touch it,  assessing  first-hand  the
numerous  sizes,  styles,  and grades of leather and leather goods.  The Company
maintains  higher inventory levels of certain imported items to assure itself of
a continuous  allotment due to the length of time required for delivery of these
items.

     The Company's  sales/distribution units are staffed by experienced managers
who are primarily compensated based upon the operating profit of their location.
Sales of these  units are  generated  by the  selling  efforts  of the  location
personnel  themselves,  participation  by the Company at trade shows, the use of
sales  representative  organizations  and  the  aggressive  use of  direct  mail
advertising.  In addition to generating mail order business,  the purpose of the
Company's  direct mail program is to stimulate sales for the  sales/distribution
units. The Company utilizes an internally  developed and maintained mailing list
which allows for very targeted mailing to its various  customer  groups.  As for
the utilization of direct mail and rapid delivery,  the Company locates units in
order to get merchandise in the customers'  hands as soon as possible,  with the
added benefit of lower freight cost.

     The  Company  attempts  to  maintain  the  number  of  stock-keeping  units
("SKU's")  in the primary  Leather  Factory line of  merchandise  at the optimum
number of items  necessary  to balance the  maintaining  of the proper  stock to
minimize  stock-out  situations  with the carrying  costs  involved with such an
inventory  level. The number of SKU's has been refined over the years due to the
introduction  of new  products  as well as the  discontinuing  of items from the
product line. The Company now maintains  2,357 items in The Leather Factory line
of  merchandise,  and the product line sold to shoe repair shops and shoe stores
increases  the number in the  Company's  overall  product line to  approximately
4,000 SKU's.

     Expansion  and  Acquisition  Strategy.  In past years the  Company has made
several  acquisitions and opened new  sales/distribution  units. The acquisition
strategy involved: (a) the purchase of businesses selling a related product line
to which The Leather Factory line of merchandise and Concept could be added; and
(b) the purchase of related  businesses.  The results of these  activities  have
been mixed  principally  due to the impact upon the  Company of negative  market
forces,  which affected the integration and results of these companies  acquired
or new locations instituted, as well as due to a protracted labor dispute at the
Cushman  facility.  Market  conditions have been challenging in the areas of the
western and craft  industries  served by the Company for some time. For example,
conditions  in the  western  industry  peaked in 1994 and the  trends  have been
generally negative in that industry since that time. These trends,  coupled with
the labor dispute at Cushman which was resolved in 1996, have affected the sales
and   profitability  of  the  Company's  Cushman   acquisition.   The  Company's
acquisition of businesses  involved in the  distribution of shoe care and repair
supplies have been only marginally profitable because of competitive pressures.

     In  1997,  management  focused  on  stabilizing  operations  and  obtaining
long-term  financing,  and no acquisitions  were made.  Subject to obtaining the
necessary  financing  and  the  demands  of  existing  operations,  the  Company
currently   plans  to  resume   its   expansion   by:  (i)  adding  one  to  two
sales/distribution  units per year;  and (ii)  acquiring  companies  in  related
areas/markets  which offer  synergistic  aspects based on the  locations  and/or
product lines of the businesses.

     It is anticipated  that the Company would not acquire a business that sells
shoe  care and  repair  supplies  as a means of  gaining a new  Leather  Factory
location as it has several times in the past. The Company has determined that it
is better to open new locations  than to purchase  these  existing  shoe-related
businesses.  The opening of a new location  requires  approximately  $100,000 in
inventory and $25,000 in fixtures,  plus the  investment in accounts  receivable
during the initial phase of a new unit.  Management  believes that new locations
can be financed internally.

     The  financing of  acquisitions  is dependent  upon the  Company's  working
capital  line of credit with FINOVA and subject to the size of the  acquisition,
will require the Company to seek  additional  financing.  Management can give no
assurances as to its ability to obtain such financing.


                                       4

<PAGE>


     Products/Customers.  The Company's core business consists of manufacturing,
importing  and  distributing   leather,   traditional   leathercraft   materials
(do-it-yourself  kits, stamping sets, and leatherworking  tools),  craft-related
items (leather  lace,  beads,  and wearable art  accessories),  hardware,  metal
garment accessories (belt buckles, belt buckle designs, and conchos),  fancy hat
trims in braids,  leather,  and woven  fabrics,  shoe care and repair  supplies,
leather finishes, and small finished leather goods. The Company's  manufacturing
operations  are in Fort  Worth,  Texas and New York,  New York at  Cushman.  The
products  manufactured  in Fort Worth  generally  involve  cutting  leather into
various  shapes  and  patterns  using  metal  dies  ("clicking"),   fabrication,
assembly, and  packaging/repackaging  tasks. The manufacturing operation in Fort
Worth makes items  primarily  for  wholesale  distribution  using the  Company's
sales/distribution  units or for drop-shipment directly to customers through the
central  warehouse.  The  Cushman  facility  manufactures  hat  trims  and small
finished leather goods. Hat trims are sold to hat manufacturers and distributors
directly.  Small  finished  leather goods are sold to various  distributors  and
retailers   through   attendance   at   trade   shows   and  the  use  of  sales
representatives.

     The customer groups served include wholesale distributors,  tack and saddle
shops,  shoe-findings  customers,  institutions,  prisons and prisoners,  dealer
stores,  western stores,  craft stores and craft store chains, hat manufacturers
and distributors,  other large volume purchasers,  manufacturers, and retailers.
No single  customer's sales comprise more than 10% of the Company's total sales.
Approximately 4% of the Company's sales are export sales.

     Competition.  The Company competes in four highly fragmented  markets which
include  leathercraft,  leather  accessories,  retail  craft,  and shoe care and
repair supplies.  Management believes that the Company encounters competition in
connection  with  certain  product  lines and in certain  areas  from  different
companies,  but has no direct competition affecting the entire product line. The
Company is larger than most of its direct competitors.  The fragmented nature of
these markets is the primary reason for the lack of broad-based competition.

     The Company  competes on price,  availability of merchandise,  and speed of
delivery.  The size of the Company  relative to most of its competitors  creates
competitive  advantage  in its ability to stock a full range of products as well
as in buying merchandise. The Company believes it has a competitive advantage on
price  in  most  product   lines  because  it  purchases  in  bulk  and  has  an
international network of suppliers that can provide quality merchandise at lower
costs.  Most of the Company's  competitors  do not have the multiple  sources of
supply and cannot purchase sufficient  quantities to compete along a broad range
of products.  In fact,  some of the Company's  competitors  are also  customers,
relying on the Company as a supplier.

     Suppliers.  The Company currently  purchases  merchandise and raw materials
from approximately 200 vendors dispersed throughout the United States as well as
in fourteen  foreign  countries.  In fiscal year 1997, the Company's ten largest
vendors  accounted  for  approximately  53% of its total  purchases.  Management
believes  that  its  relationships  with  suppliers  are  strong  and  does  not
anticipate any material  changes in these supplier  relationships in the future.
Due to the number of  alternative  sources of supply,  the loss of any or all of
these principal  suppliers would not have a material impact on the operations of
the Company.

     Patents and Copyrights.  The Company presently owns 130 copyrights covering
238  registered  works with one work pending,  seven  trademarks  covering seven
names with one trademark  application  pending,  and two patents  covering three
products. Registered trademarks include a federal trade name registration on The
Leather  Factory.  The  trademarks  expire at various times starting in 2002 and
ending in 2007,  but can be renewed  indefinitely.  Most  copyrights  granted or
pending  are on  metal  products,  such as  conchos,  belt  buckles,  etc.,  and
instruction  books. The expiration  period for the copyrights begins in 2062 and
ends  in  2071.  The  Company  has  patents  on two  belt  buckles  and  certain
leather-working  equipment known as the "Speedy Embosser." The patents expire in
2011.  Management  considers these intangibles to be valuable assets and defends
them as necessary.

     Compliance With Environmental Laws. Compliance by the Company with federal,
state and local  environmental  protection laws has not had, and is not expected
to  have,  a  material  effect  upon  capital  expenditures,   earnings  or  the
competitive position of the Company.


                                       5


<PAGE>


     Employees.  As of December 31, 1997, the Company employed 214 people,  with
206  on a  full  time  basis.  The  Company  is not a  party  to any  collective
bargaining  agreement.  Eligible  employees  participate in The Leather Factory,
Inc.  Employees'  Stock  Ownership Plan and Trust  ("ESOP").  As of December 31,
1997, 169 employees and former  employees were  participants in or beneficiaries
of the ESOP.  The Company has the option of  contributing  up to 15% of eligible
employees' compensation into the ESOP. Net contributions for 1997, 1996 and 1995
were  1.2%,  .8%,  and  .8%   respectively  of  eligible   compensation.   These
contributions are used to purchase shares of Common Stock.

     In late October 1995,  representatives of Union Local 62-32 of the Union of
Needletrades,  Industrial,  and Textile Employees  ("UNITE")  requested that the
Company's  wholly owned  subsidiary,  Cushman,  recognize  UNITE as the sole and
exclusive employee bargaining representative. The Company responded by declining
to recognize  UNITE unless a secret ballot election was held by the employees of
Cushman.  On October 31,  1995,  the  employees of Cushman went on strike in New
York City for the purpose of securing  representation.  Virtually  all of the 50
hourly  employees of Cushman refused to cross the picket line. The Company filed
charges with the National Labor  Relations  Board ("NLRB")  alleging that picket
line misconduct and violence was inspired by UNITE.

     The strike  lasted from  October  31, 1995 to April 1, 1996,  at which time
UNITE notified the Company that it would cease all organizing actions so long as
an  unconditional  return to work was made to all  employees  who had refused to
cross the picket line. On August 1, 1996, a secret ballot  election was held and
the union was defeated.

     On September 6, 1996, Cushman and UNITE entered into a settlement agreement
approved by the NLRB,  to  completely  settle and resolve the issues noted above
without  the need for a trial.  While not  admitting  that  Cushman  committed a
violation  of the  National  Labor  Relations  Act (the "Labor Act") or that the
employees engaged in an unfair labor practice strike,  Cushman did agree to post
a notice in English and Spanish informing  employees of their rights pursuant to
the Labor Act and Cushman's agreement to not: (i) interrogate employees relative
to union activities; (ii) threaten employees with the relocation of the business
if they  support  UNITE or any other  labor  organization;  (iii) warn or advise
employees that their continued  employment is conditioned upon their abandonment
of their support for UNITE or any other labor  organization;  and (iv) interfere
with, restrain or coerce employees in the exercise of the rights guaranteed them
by the Labor Act.

     Except  for any  residual  affects  due to  attempts  by UNITE to  organize
employees of Cushman as described above, management believes that relations with
employees are good.


                                       6

<PAGE>


Item 2.   Properties.

     The  Company  leases  all its  premises.  The  Company  sold its only owned
location on December 15, 1997.  This  property,  which was a 13,287  square foot
office/warehouse  building  located  on a  16,550  square  foot  site in  Tampa,
Florida, was pledged as collateral under the Company's Senior Debt Facility with
FINOVA.  A portion of the  indebtedness  to FINOVA,  in the principal  amount of
$236,000, was paid from the net proceeds received upon the sale.

     Detailed below are the lease terms for the Company's locations. The general
character of each location is light industrial  office/warehouse  space,  except
for the New York City premises which is standard light  industrial loft space in
a multi-story  building.  The Company  believes that all of its  properties  are
adequately covered by insurance.

<TABLE>

<S>                                                                                  <C>

      Location Name              Total Space (Sq. Ft.)     Minimum Annual Rent *     Lease Expiration
      -------------              ---------------------     -------------------       ----------------


      Chattanooga, TN                   9,040                 $    40,704              May 1999
      Denver, CO                       12,000                      39,000              October 1999
      Harrisburg, PA                    6,850                      36,665              March 2002
      Fort Worth, TX                   61,000                     238,835              March 2003
      Fresno, CA                        5,600                      41,807              March 2002
      Des Moines, IA                    4,000                      30,718              April 1999
      Phoenix, AZ                       4,500                      25,679              March 2001
      Springfield, MO                   6,000                      20,400              July 1998
      Spokane, WA                       5,400                      20,400              February 1999
      Albuquerque, NM                   5,000                      27,600              October 1998
      Salt Lake City, UT                4,000                      25,584              September 1999
      Baldwin Park, CA                  7,800                      52,200              March 2000
      Tampa, FL                         5,238                      37,604              January 2003
      San Antonio, TX                   5,600                      40,320              October 2001
      Columbus, OH                      6,000                      38,270              October 2000
      El Paso, TX                       9,600                      44,122              July 1998
      Oakland, CA                       8,000                      57,304              December 2003
      Grand Rapids, MI                  8,000                      33,951              March 1999
      Wichita, KS                      14,000                      33,600              May 1999
      New York, NY                     12,000                      94,080              September 1998
      New Orleans, LA                   5,130                      21,600              August 2000
      Charlotte, NC                     6,202                      24,188              February 2001
      Winnipeg, Canada                  5,712                      28,085**            November 2002
                                     --------                 -----------
      Totals                          216,672                 $ 1,052,716
                                     ========                 ===========



</TABLE>

     *  Represents  the  average  minimum  annual  rent over the  balance of the
     unexpired lease term.
     ** As converted into U.S. dollars.

     The   Company's   Fort   Worth    location    includes   the   Fort   Worth
sales/distribution   unit,   the   Company's   central   warehouse,   the  light
manufacturing facility, and the sales and administrative/executive  offices. The
Company also leases a 624 square foot  showroom in the Denver  Merchandise  Mart
for $10,920 per year. This lease will expire in October 1998.




                                       7


<PAGE>

Item 3.   Legal Proceedings.

     The Company, as  successor-in-interest to National, has been a defendant in
a  lawsuit  brought  in July  1994 by Gary A.  Bedini  and John C.  Bedini  (the
"Plaintiffs")  in the United States District Court for the District of Colorado.
Additional defendants are Securities Transfer  Corporation,  a Texas corporation
("STC"),  and Steven Jay Olson,  individually,  and as President and Director of
National,  now known as The Leather Factory, Inc. The Plaintiffs alleged that in
1992,  pursuant to SEC Rule 144(k),  they sought to transfer  approximately  1.5
million shares of their Common Stock in Gamma Electronic Systems, Inc., and that
the  transfer  agent,  National,   improperly  refused.  The  Plaintiffs  sought
compensatory  damages in the amount of $2.1 million as well as punitive damages.
The Company is  contractually  indemnified  from and against all losses that may
arise out of this  cause of action,  including  attorneys'  fees,  by STC and/or
related entities.

     This action was tried in July 1995.  Upon the conclusion of the trial,  the
judge found in favor of one plaintiff,  Gary Bedini,  and against the defendants
in the amount of $50,468,  and similarly for the other  plaintiff,  John Bedini,
and against the defendants in the amount of $68,548. The written judgment of the
court (the "Judgment"),  which reflected the aforementioned rulings by the trial
judge,  was entered on  September  7, 1995.  This  Judgment  also  included  pre
judgment  interest of $16,159 for Gary Bedini and $21,947 for John Bedini.  Post
judgment interest continues to accrue from the date of the Judgment, pursuant to
federal law.

     According to the terms of its contractual indemnification  obligations, STC
has defended this  litigation at its expense.  On September 21, 1995,  STC filed
Defendants'  Motion to Alter or Amend  Judgment (the  "Motion").  The Plaintiffs
filed a response  to this  Motion on October 4, 1995,  and said  Motion  remains
pending.  In addition to the Motion,  STC has made a settlement  offer.  STC has
informed the Company if the case does not settle, and the Motion is denied, then
STC intends to appeal the Judgment and to post either a supersedeas bond or cash
to avoid  collection  of the Judgment  while the appeal is pending.  As of March
1998,  no action  has been  taken by the trial  judge  relative  to the  Motion.
Pursuant to the  Indemnification  Agreement  between  STC and the Company  dated
October 17,  1994,  the Company  believes it will not suffer any loss due to the
action described here and above.

     The Company has  litigation in the ordinary  course of its business.  Other
than described  above,  the Company is not a party to any material pending legal
proceedings.


Item 4.   Submission of Matters to a Vote of Security Holders.

     There were no matters submitted to a vote of the Company's security holders
during the fourth quarter of the Company's fiscal year ended December 31, 1997.









                                       8


<PAGE>


                                     PART II


Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters.

     The Common  Stock of the Company is traded on the American  Stock  Exchange
using the symbol TLF. The high and low prices for each calendar  quarter  during
the last two fiscal years are as follows:

         Quarter Ended                     High                        Low


         March 31, 1996                   $2.6875                     $1.7500
         June 30, 1996                     2.1250                      1.7500
         September 30, 1996                1.9375                      1.4375
         December 31, 1996                 1.4375                      0.8125


         March 31, 1997                    1.0000                      0.5625
         June 30, 1997                     0.8125                      0.5000
         September 30, 1997                0.8750                      0.5625
         December 31, 1997                 0.8125                      0.5000
----------
    There were approximately 585 stockholders of record on March 18, 1998.

         There have been no cash  dividends  paid on the shares of the Company's
Common  Stock and  currently  dividends  cannot be declared or paid  without the
prior  written  consent of FINOVA  Capital  Corporation,  the  Company's  senior
lender. The Board of Directors has historically followed a policy of reinvesting
the  earnings of the Company in the  expansion of its  business.  This policy is
subject to change based on current  industry and market  conditions,  as well as
other factors beyond the control of the Company.














                                       9





<PAGE>

Item 6.  Selected Financial Data.

    The selected  financial data presented  below are derived from and should be
read in conjunction  with the Company's  Consolidated  Financial  Statements and
related notes. This information should also be read in conjunction with Item 7 -
"Management's  Discussion  and  Analysis of Financial  Condition  and Results of
Operations."

<TABLE>

<S>                                                                             <C>             <C>                <C>

Years Ended December 31
---------------------------
Income Statement Data
                                       ---------------------------------------------------------------------------------------------
                                            1997               1996               1995               1994                1993
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Net sales                                 $25,399,116         $28,253,632        $31,447,849        $28,081,272         $24,371,082
Cost of sales                              14,844,376          17,689,973         18,446,378         15,870,603          13,555,345
                                       ---------------    ----------------   ----------------   ----------------    ----------------
     Gross profit                          10,554,740          10,563,659         13,001,471         12,210,669          10,815,737

Operating expenses                          9,365,673          10,869,359         10,363,159          9,573,495           8,631,600
                                       ---------------    ----------------   ----------------   ----------------    ----------------
Operating income (loss)                     1,189,067           (305,700)          2,638,312          2,637,174           2,184,137

Other (income) expense                        887,543           1,000,604            678,264            142,830             149,955
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Income (loss)
     before income taxes                      301,524         (1,306,304)          1,960,048          2,494,344           2,034,182
Income tax provision (benefit)                231,232           (316,536)            786,744            990,197             875,362*
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Net income (loss)                              70,292           (989,768)          1,173,304          1,504,147           1,158,820*
                                       ===============    ================   ================   ================    ================

Earnings (loss) per share**                       .01               (.10)                .12                .15                 .13*
                                       ===============    ================   ================   ================    ================

Earnings (loss) per share--
  assuming dilution**                             .01               (.10)                .12                .15                 .13*
                                       ===============    ================   ================   ================    ================

Weighted average common
shares outstanding for:

   Basic EPS                                9,789,358           9,788,530          9,789,468          9,783,387           8,801,422
                                       ===============    ================   ================   ================    ================

   Diluted EPS                              9,791,565           9,788,530          9,789,468          9,783,387           9,035,568
                                       ===============    ================   ================   ================    ================

Balance Sheet Data
                                       ---------------------------------------------------------------------------------------------
                                             1997               1996               1995               1994                1993
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Total Assets                              $17,024,549         $18,264,547        $19,333,376        $18,468,806          $9,555,881
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Notes payable and current
    maturities of long term debt            4,650,742           8,549,366          1,296,359            194,311             216,572
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Notes payable and long-term
    debt, net of current maturities         2,602,728              17,378          6,566,809          7,325,432           1,189,856
                                       ---------------    ----------------   ----------------   ----------------    ----------------

Total Stockholders' Equity                  8,132,646           8,022,937          9,282,305          8,217,781           5,502,452
                                       ===============    ================   ================   ================    ================
</TABLE>


* Includes charge of $98,772 or $0.01 per share reflecting  cumulative effect on
prior years of a change in accounting method for income taxes (SFAS 109).

** The earnings  (loss) per share  amounts  prior to 1997 have been  restated to
comply with Statement of Financial  Accounting  Standards No. 128,  Earnings Per
Share. Such restatement did not change previously reported amounts.  See notes 2
and 8 to  the  consolidated  financial  statements  for  further  discussion  of
earnings per share.



                                       10


<PAGE>


Item 7.  Management's Discussion and Analysis of Financial Condition and Results
         of Operations.

General

     The Leather  Factory,  Inc.  ("TLF" or the  "Company") is an  international
manufacturer  and wholesale  distributor  of a broad product line which includes
leather,  leatherworking  tools, buckles and other belt supplies,  shoe care and
repair  supplies,  leather dyes and finishes,  adornments  for belts,  bags, and
garments,  saddle and tack  hardware,  and  do-it-yourself  kits.  The  Company,
through its subsidiary,  Roberts,  Cushman & Company, Inc.  ("Cushman"),  in New
York, New York, produces hat trims, the decorative piece of material that adorns
the outside of a hat, and small finished leather goods and accessories.

     The Company  principally  promotes its products through the use of targeted
direct  mail  advertising.  Proprietary  mailing  lists by  customer  groups are
maintained by the Company.  These  valuable  mailing  lists have been  generated
internally  and have never  been sold to third  parties.  The sales from  direct
mailings are serviced by the Company's 21 sales/distribution units located in 17
states and one in Canada. These locations offer one-stop shopping and are placed
geographically to ensure rapid delivery to the customer.

     In  addition  to  marketing   capability,   the  Company   performs   light
manufacturing as well as packaging tasks in its manufacturing facilities located
in Fort Worth,  Texas and New York, New York. If the Company cannot  manufacture
an item on a cost  effective  basis,  the product will be located and  purchased
from virtually anywhere in the world. The Company currently procures goods in 14
countries around the world.

     The Company  frequently  introduces  new  products  either  through its own
manufacturing  capability or through purchasing from vendors.  One indication of
the Company's  expertise in the area of product  development is the  substantial
number of  copyrighted  designs which the Company owns.  These designs have been
incorporated  throughout the Company's  product line,  including hat trims, as a
means of increasing its competitive advantage.

Results of Operations

                                         Income Statement Comparison

     The following  table sets forth,  for the fiscal years  indicated,  certain
items  from the  Company's  Consolidated  Statements  of Income  expressed  as a
percentage of net sales:

<TABLE>

<S>                                                                             <C>      <C>

                                                            1997               1996               1995
                                                  ---------------     --------------     --------------
        Net Sales                                          100.0%            100.0%              100.0%

        Cost of sales                                       58.4              62.6                58.7
                                                  ---------------     --------------     --------------
        Gross profit                                        41.6              37.4                41.3

        Operating expenses                                  36.9              38.5                33.0
                                                  ---------------     --------------     --------------
        Income (loss) from operations                       4.7               (1.1)                8.3

        Other (income) expense, net                         3.5                3.5                 2.1
                                                  ---------------     --------------     --------------
        Income (loss) before
          income taxes                                      1.2               (4.6)                6.2

        Provision (benefit) for income tax                  0.9               (1.1)                2.5
                                                  ---------------     --------------     --------------
        Net income (loss)                                   0.3%              (3.5)%               3.7%
                                                  ===============     ==============     ==============

</TABLE>

                        Analysis of 1997 Compared to 1996

Revenues

     The Company's net sales decreased by 10.1% to $25,399,116  during 1997 from
$28,253,632 in 1996.  This sales decline was a result of the negative  forces at
the retail  level that existed in some of the  Company's  markets as well as the
Company's plan to achieve  greater  margins through higher prices which led to a
lower volume of sales. The Company experienced reduced revenues of $1,507,140 in
sales of western or southwestern  related  products and $983,399 in sales to the
retail craft industry.


                                       11


<PAGE>


     With the bankruptcy  and  reorganization  of another craft retailer  during
1997, Old America Stores (Ben Franklin filed for bankruptcy protection in 1996),
as well as the retrenchment by other retailers,  the Company experienced another
year of reduced sales to the retail craft market. The Company's attempts in cost
cutting  may have  also  contributed  to  decreased  sales to the  retail  craft
industry.  For instance,  in late 1996, the Company terminated its relationships
with many of the sales  representative  organizations  that  provided  sales and
customer  support  to the retail  craft  industry.  The  Company  assumed  these
responsibilities directly and saved approximately $170,000 in commissions during
1997.  This was certainly at the expense of some amount of sales  although it is
difficult to quantify since many large craft  retailers  prefer to deal directly
with the Company anyway.

     Similar market conditions existed for the Company in its product lines that
were western-related. Sales by retailers of western apparel and accessories have
generally  been in decline since 1994.  This  negatively  impacted the Company's
sales of its products to these  retailers as well as its sales to other  western
apparel and accessory manufacturers.  For example, Cushman manufactured and sold
fewer hat trims in part because fewer western hats were being sold.

     In addition to sales declines due to negative external forces,  the Company
initiated and implemented  certain  strategies  during the year that resulted in
lower sales. Prices in lower margin product lines were selectively increased and
certain  products were eliminated from these lines.  For example,  the Company's
line of  products  relating  to shoe care and  repair  was  reduced by more than
one-half  during the year.  Also,  less focus was placed on sales involving high
volume but low margins such as sales of bulk leather.  These  merchandising  and
pricing strategies  contributed to the sales decline by approximately  $950,000.
This  decline was  partially  offset by  increases  generated  in the  Company's
growing line of finished  leather  accessories  and an increase in export sales.
Finished  leather   accessory  sales  and  export  sales  made  up  2%  and  4%,
respectively  of the  Company's  sales during 1997 and increased at the rates of
182.8% and 15%,  respectively.  These increases in leather  accessory and export
sales reflect  efforts of the Company to introduce new products and seek out new
opportunities to sell its existing product lines.

     Management  believes  that the  financial  and  operational  aspects of the
business have  stabilized and new attention can be directed to increasing  sales
in 1998. Market research has been conducted by the Company in order to determine
how to better  serve  some of its core  customer  groups,  and  during  1998 the
Company  intends  to focus on some of the ideas  drawn from this  research.  The
Company will also continue to exploit  initiatives which were begun in 1997 that
have  required  some time to be fully  implemented,  such as the offering of the
Company's products in the official Boy Scout catalog.

     The sales of the Company are not  seasonal.  Sales were down  approximately
10% in the  fourth  quarter  of 1997 from the same  period in 1996 and were down
rather  uniformly  throughout  the year.  It is clear  that the  Company is in a
protracted  down cycle in the craft and  western  markets.  The  majority of the
Company's  management  team has  experienced  similar  downturns twice before in
their careers.  Through new product  introduction and  attentiveness to customer
needs and desires,  the Company plans to offset any further  losses in sales and
position itself to take full advantage of  opportunities  as conditions in these
markets improve.

Costs, Gross Profit, and Expenses

     Cost of sales as a percentage  of revenue was 58.4% for 1997 as compared to
62.6% for 1996.  The  difference  in the relative cost of sales  percentage  was
principally  attributable  to: (i) a change in sales mix, in that the percentage
of the Company's sales reflecting relative lower costs of sales increased;  (ii)
management's  plan to raise prices and selectively  eliminate lower margin items
from the  Company's  product  lines;  and (iii)  direct  labor  costs  that were
eliminated due to planned  personnel  reductions and the settlement of the labor
dispute at Cushman in October of 1996.

     A lower  relative  cost of sales  percentage  meant that gross  profit as a
percentage of sales was higher for the year ended  December 31, 1997 compared to
1996.  Gross profit as a percentage of sales increased 4.2 percentage  points to
41.6% in 1997 from 37.4% in 1996. Due to the factors mentioned above relative to
cost of sales,  the Company  generated almost the same amount of gross profit in
dollars on  $25,399,116  in sales during the year ended  December 31, 1997 as it
did on $28,253,632 in sales during 1996.



                                       12

<PAGE>


     Operating expenses decreased  $1,503,686 or 13.8% to $9,365,673 during 1997
from $10,869,359 in 1996. This decrease in operating expenses was the net result
of cost control measures instituted by management.

     The specific  reductions in operating  expenses  involved  several factors,
including the following significant elements:  (i) reduced payroll,  payroll tax
and payroll related  expenses of  approximately  $500,000 due to a substantially
lower average number of employees during 1997 compared to 1996; (ii) a small bad
debt  recovery  was  recorded  during 1997 as opposed to $229,000 of expense for
1996,  principally  due to $120,665 in bad debt expense because of a significant
customer  declaring  Chapter 11 bankruptcy during 1996; (iii) a net reduction in
commission   expense  of  $151,183  occurred  in  1997,  due  primarily  to  the
elimination of sales representatives in the retail craft market partially offset
by an increase of $19,052 in  commissions  paid at Cushman  attributable  to the
Company's  line of finished  leather  goods;  (iv)  $140,772  less  amortization
expense  was  recorded  in 1997 as opposed to 1996,  principally  because of the
write down of certain  purchased  goodwill  during 1996; and (iv)  reductions of
$50,000  or more  in  each  of  advertising,  corporate  fees  and  shareholders
relations,  freight,  insurance,  supplies, travel, and marketing samples. These
decreases in operating expenses were partially offset by increased  professional
expenses  incurred  by the  Company in initial  efforts to obtain new  financing
during 1997.

Other (Income) Expense

     Other  expenses were $887,543 for the year ended December 31, 1997 compared
to $1,000,604  during the same period in 1996.  The  difference  between the two
years involved decreased  interest expense.  The difference in the dollar amount
of  interest  expense  was  principally  due to the  write-off  in  1996  of the
commitment and facility fees  attributable to the acquisition  commitments  that
expired in July 1996.  The interest  expense  that the Company  could have saved
during 1997 from  decreased  levels of debt compared to the previous  year,  was
offset  by  increased  interest  rates  and  the  forbearance  fees  charged  by
NationsBank.  Due to the Company's  continuing  default under certain  covenants
contained in the  NationsBank  debt  facility,  the rate of interest  charged by
NationsBank increased from an average of the Prime Rate or less during the prior
fiscal year to the Prime Rate plus 2% on average for 1997.

Provision (Benefit) for Income Taxes

     The  provision  for federal and state  income  taxes was 77% of 1997 income
before  taxes  due  to  certain   non-deductible   expenses  totaling  $235,000,
principally comprised of the amortization of goodwill.  Taking this into account
the  Company's   effective  tax  rate  materially   approximates  the  Company's
historical rate for combined federal and state income taxes of about 40%.

Net Income

     The  Company  recorded  net  income  of  $70,292  for 1997 as  compared  to
reporting  a net loss of  $989,768  during  1996.  The  change  in  results  was
primarily due to the factors noted above  regarding  sales,  cost of goods sold,
operating expenses and other (income) expense.


                        Analysis of 1996 Compared to 1995

Revenues

     The Company's net sales decreased by 10.2% to $28,253,632  during 1996 from
$31,447,849 in 1995.  The 10.2% decrease in revenues was primarily  comprised of
two  pieces.  Reduced  sales to the retail  craft  industry  comprised  7.7% and
reduced sales at Cushman comprised 2.7%. The Company's sales to the retail craft
industry  and its sales at  Cushman  during  1996 were  negatively  impacted  by
challenging retail environments in the craft and western markets.

Costs, Gross Profit, and Expenses

     Cost of sales as a percentage  of revenue was 62.6% for 1996 as compared to
58.7% for 1995.  The  difference  in the relative cost of sales  percentage  was
principally  attributable to a change in sales mix, price  competition in a very
competitive  market environment and direct labor costs associated with the labor
dispute at Cushman.

                                       13

<PAGE>


     Operating  expenses  increased  $506,200 or 4.9% to $10,869,359 during 1996
from $10,363,159 during 1995. The increase in operating expenses between the two
periods  was due to  various  factors,  including  (i) an  increase  in bad debt
expense of  $120,665  because of a  significant  customer  declaring  Chapter 11
bankruptcy, (ii) expenses associated with two new locations, (iii) write down of
certain  purchased  goodwill due to its impairment,  (iv) increased  advertising
expense to  generate  new sales and (v) an  increase  in  operating  expenses at
Cushman, some of which were related to previous labor problems.  These increases
in operating expenses were partially offset by lower  discretionary  bonuses and
commissions.

Other (Income) Expense

     Other  expenses  were  $1,000,604  for 1996 as compared to $678,264  during
1995.  This increase was primarily  due to the write-off of the  commitment  and
facility  fees  attributable  to the  acquisition  financing  commitments  which
expired in July 1996, and an increase in interest  expense due to an increase in
the outstanding balance on the working capital line of credit.

Provision (Benefit) for Income Taxes

     The benefit for income  taxes was 24% of the loss  before  income  taxes in
1996,  as compared to a provision for income taxes of 40% of income before taxes
in  1995.  This  difference  is  primarily  a  result  of  an  increase  in  the
amortization of non-deductible goodwill.

Net Income

     The  Company  incurred  a net  loss of  $989,768  for 1996 as  compared  to
reporting  net income of $1,173,304  during 1995.  The loss was primarily due to
the factors noted above regarding sales, cost of goods sold,  operating expenses
and other (income) expense.

Capital Resources and Liquidity

     The primary  sources of liquidity  and capital  resources  during 1997 were
borrowings on the Company's  credit facility with  NationsBank,  the Senior Debt
Facility with FINOVA and the  Subordinated  Debenture with  Schlinger,  and cash
flows provided by operating activities.

     While having a negative  impact on sales,  the  Company's  focus in 1997 on
improving gross profit margins and reducing  operating expenses was effective as
indicated by the strong cash flows from  operations in the amount of $1,605,305.
The use of cash  flows  from  operations  to pay down debt is  reflected  in the
improvement of the Company's debt to equity ratio from 1.07 at December 31, 1996
to 0.89 at December 31, 1997.

     Some of this  improvement in cash flow resulted from the Company's  ability
to reduce its investment in accounts  receivable and inventory given the reduced
level of sales.  Accounts  receivable  decreased  to  $1,865,276  and  inventory
decreased to $7,279,702  at December 31, 1997 from  $1,947,698  and  $7,737,320,
respectively,  at December 31, 1996.  The aging of accounts  receivable  has not
deteriorated  and is  indicative  of  managements'  continued  tight  credit and
collection  policies which have also  contributed to the negative trend in sales
noted above.

     Even at the reduced  level,  inventory  only turned 1.98 times during 1997,
which is below the 1996  ratio of 2.26  times.  This  decrease  in the turn rate
indicates  that further  reductions in inventory are still needed as of December
31,  1997  for  the  current  level  of  sales.   Management   anticipates   the
implementation of new information systems will assist in monitoring of inventory
levels in 1998.

     The refinancing of the Company's debt on a long-term basis (as discussed in
Item  1 and  Note 3 to  the  Consolidated  Financial  Statements)  improved  the
Company's financial position  substantially.  For example, the Company's monthly
debt  service  requirements  are  approximately  $30,000  less  than  under  the
Company's  prior  arrangements.  As  discussed in Note 3, the  revolving  credit
portion of the Senior Debt Facility  ($4,030,519  at December 31, 1997) is shown
as current  because  of an  accounting  requirement  when the  revolving  credit
agreement contains both a subjective  acceleration  clause and a requirement for
an arrangement  whereby cash collections  directly reduce the debt  outstanding.
Management  does not believe  that any such  acceleration  will occur and absent
such required  classification,  the Company's current ratio would have been 4.86
at December 31, 1997 compared to 1.13 at the end of 1996.


                                       14

<PAGE>

     The Senior Debt  Facility is now comprised of a revolving  credit  facility
("Revolving  Credit Loan") and two term notes.  The  revolving  portion is based
upon the level of the Company's accounts  receivable and inventory.  At December
31,  1997,  the Company had  additional  availability  on the  revolving  credit
facility of approximately $377,000. As the Company's sales and operations expand
requiring larger investments in accounts  receivable and inventory,  the Company
could have almost  $3,000,000 in additional  funds available under the Revolving
Credit Loan.

     The  largest  use of cash  beyond  debt  payments  in 1997 was for  capital
expenditures.  Cash used for capital  expenditures totaled $239,578 and $208,537
for the  years  ended  December  31,  1997  and  1996,  respectively.  The  1997
expenditures  principally  relate to the new  computer  system  presently  being
installed and implemented,  with the 1996 amounts relating to: (i) new equipment
acquired to open the Charlotte,  NC sales/distribution  unit; (ii) new equipment
for the Fort Worth  manufacturing  facility;  and (iii) the  purchase of various
equipment,  office  furniture and  fixtures.  The Company  received  proceeds of
$257,306 in 1997 from the sale of the  Company's  land and  building  located in
Tampa, Florida. The Company now leases the site for its sales/distribution  unit
in Tampa, Florida.

     The Company  believes  that the current  sources of  liquidity  and capital
resources  will be sufficient to fund current  operations and the opening of new
sales/distribution  units.  In 1998, the funding for the opening of new units is
expected  to  be  provided  by  operating  leases,  cash  flows  from  operating
activities, and the Company's Revolving Credit Loan with FINOVA.

     The  Company's  new  financings  with both FINOVA and  Schlinger  mature on
December 1, 1999 and management  intends to pursue  negotiations with FINOVA and
other  potential  lenders in late 1998 and early  1999 to extend or replace  the
maturing  notes.  Management  believes  it will be able to secure  the  required
financing  prior to the  maturity  of these  loans.  However,  in the event of a
future  material  adverse  change  in the  Company's  operations,  FINOVA  could
accelerate  their debt or otherwise  determine not to renew the notes. In such a
circumstance,  the Company  would pursue other  sources of  financing.  If other
financing could not be secured,  the Company could experience a material adverse
impact.

     Management  perceives  opportunities  to acquire  related  business  in the
marketplace  due to the  fragmented  nature of the  markets in which the Company
conducts business as well as due to the competitive conditions of these markets.
The  Company's  present  financing  arrangements  will not be sufficient to make
these  acquisitions and if any  acquisitions are to be consummated,  the Company
will be  required  to  obtain  additional  debt  or  equity  financing.  Any new
financings  will  require  the  consent of FINOVA.  The  Company  can provide no
assurance that these acquisitions can be made on terms acceptable to the Company
or that the needed financings to enter into these transactions can be obtained.

Year 2000 Issue

     The Company has developed a plan to modify its information technology to be
ready  for the year  2000 and has  begun  converting  critical  data  processing
systems.  At December 31, 1997,  the majority of systems had been converted with
total cost to date of less than  $100,000.  The  Company  does not  expect  this
project to have a significant  effect on operations  nor any material  remaining
costs to be incurred.



                                       15

<PAGE>




Cautionary Statement

     The disclosures  under "-Results of  Operations";  "-Capital  Resources and
Liquidity";  "Year  2000  Issue"  and in the  Notes  to  Consolidated  Financial
Statements as provided elsewhere herein contain  forward-looking  statements and
projections of management. There are certain important factors which could cause
results  to  differ   materially   than  those   anticipated   by  some  of  the
forward-looking  statements.  Some of the  important  factors  which could cause
actual results to differ materially from those in the forward-looking statements
include,  among other things,  changes from anticipated levels of sales, whether
due  to  future  national  or  regional  economic  and  competitive  conditions,
including,  but not limited to,  retail  craft  buying  patterns,  and  possible
negative trends in the craft and western retail markets,  customer acceptance of
existing and new products,  or otherwise,  pricing  pressures due to competitive
industry  conditions,  increases  in prices for  leather,  which is a world-wide
commodity,  which for some reason,  may not be passed on to the customers of the
Company's products, change in tax rates, change in interest rates, change in the
commercial  banking  environment,  problems with the importation of the products
which the Company  buys in 14  countries  around the world,  including,  but not
limited to,  transportation  problems or changes in the political climate of the
countries involved,  including the maintenance by said countries of Most Favored
Nation status with the United States of America, and other uncertainties, all of
which are  difficult  to predict and many of which are beyond the control of the
Company.


Item 8.  Financial Statements and Supplementary Data.

     The Financial  Statements and Financial  Statement  Schedule are filed as a
part of this report. See page 17, Index to Consolidated Financial Statements.


Item 9.  Change In and Disagreements with Accountants on Accounting and
         Financial Disclosure.


         None.


















                                       16


<PAGE>


                            THE LEATHER FACTORY, INC.



                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


<TABLE>

<S>                                                                              <C>                      <C>

Consolidated Balance Sheets at December 31, 1997 and 1996.................................................18

Consolidated Statements of Income For the Years Ended December 31, 1997, 1996 and 1995....................19

Consolidated Statements of Cash Flows For the Years Ended December 31, 1997, 1996 and 1995................20

Consolidated Statements of Stockholders' Equity For the Years Ended December 31, 1997, 1996 and 1995......21

Notes to Consolidated Financial Statements................................................................22-31

Financial Statement Schedules for the years ended December 31, 1997 and 1996:

     II -- Valuation and Qualifying Accounts and Reserves.................................................32

     All other  schedules  are omitted  since the  required  information  is not
present or is not present in amounts  sufficient  to require  submission  of the
schedule or because  the  information  required is included in the  consolidated
financial statements and notes thereto.

Reports of Independent Auditors...........................................................................33-34

</TABLE>











                                       17


<PAGE>


<TABLE>

<CAPTION>

                            THE LEATHER FACTORY, INC.
                           CONSOLIDATED BALANCE SHEETS
                           December 31, 1997 AND 1996

<S>                                                                             <C>         <C>

                                                                             1997                 1996
                                                                        --------------       --------------
                                ASSETS
CURRENT ASSETS:
     Cash                                                               $      70,496        $     488,192
     Cash restricted for payment on revolving credit facility                 319,133                    -
     Accounts receivable-trade, net of allowance for
         doubtful accounts of $28,000 and $54,000
          in 1997 and 1996, respectively                                    1,865,276            1,947,698
     Inventory                                                              7,279,702            7,737,320
     Prepaid income taxes                                                     285,970              538,458
     Deferred income taxes                                                    109,411              126,955
     Other current assets                                                     385,199              542,809
                                                                        --------------       --------------
                           Total current assets                            10,315,187           11,381,432
                                                                        --------------       --------------

PROPERTY AND EQUIPMENT, at cost                                             2,534,839            2,672,253
  Less: accumulated depreciation and amortization                          (1,505,098)          (1,273,609)
                                                                        --------------       --------------
                           Property and equipment, net                      1,029,741            1,398,644

GOODWILL and other, net of accumulated amortization of
     $878,000 and $660,000 in 1997 and 1996, respectively                   5,679,621            5,484,471
                                                                        --------------       --------------
                                                                        $  17,024,549        $  18,264,547
                                                                        ==============       ==============

                 LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
     Accounts payable                                                   $     942,046        $     940,549
     Accrued expenses and other liabilities                                   559,776              597,007
     Notes payable and current maturities of
         long-term debt                                                     4,650,742            8,549,366
                                                                        --------------       --------------
                           Total current liabilities                        6,152,564           10,086,922
                                                                        --------------       --------------

DEFERRED INCOME TAXES                                                         136,611              137,310

NOTES PAYABLE AND LONG-TERM DEBT,
     net of current maturities                                              2,602,728               17,378

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
     Preferred stock, $0.10 par value; 20,000,000
         shares authorized, none issued or outstanding                              -                    -
     Common stock, $0.0024 par value; 25,000,000 shares
         authorized, 9,853,161 shares issued in 1997 and 1996                  23,648               23,648
     Paid-in capital                                                        4,119,915            4,130,796
     Retained earnings                                                      4,534,569            4,464,277
     Less: Notes receivable - secured by common stock                        (257,617)            (269,305)
     Cumulative translation adjustments                                       (14,018)                (295)
     Less:  Unearned shares held by ESOP, 54,262 and
         64,631 shares in 1997 and 1996, respectively                        (273,851)            (326,184)
                                                                        --------------       --------------
                           Total stockholders' equity                       8,132,646            8,022,937
                                                                        --------------       --------------
                                                                        $  17,024,549        $  18,264,547
                                                                        ==============       ==============


</TABLE>


   The accompanying notes are an integral part of these financial statements.


                                       18

<PAGE>


<TABLE>
<CAPTION>

                            THE LEATHER FACTORY, INC.
                        CONSOLIDATED STATEMENTS OF INCOME
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995


<S>                                                                             <C>          <C>

                                                                1997              1996             1995
                                                           --------------    --------------   --------------

NET SALES                                                  $  25,399,116     $  28,253,632    $  31,447,849

COST OF SALES                                                 14,844,376        17,689,973       18,446,378
                                                           --------------    --------------   --------------

                Gross profit                                  10,554,740        10,563,659       13,001,471

OPERATING EXPENSES                                             9,365,673        10,869,359       10,363,159
                                                           --------------    --------------   --------------

INCOME (LOSS)  FROM OPERATIONS                                 1,189,067         (305,700)        2,638,312

OTHER (INCOME) EXPENSE:
     Interest expense                                            867,548         1,007,544          718,066
     Other, net                                                   19,995            (6,940)         (39,802)
                                                           --------------    --------------   --------------
                Total other (income) expense                      887,543        1,000,604          678,264
                                                           ---------------   --------------   --------------

INCOME (LOSS)  BEFORE INCOME TAXES                                301,524      (1,306,304)        1,960,048

PROVISION (BENEFIT) FOR INCOME TAXES                              231,232        (316,536)          786,744
                                                           ---------------   --------------   --------------

NET INCOME (LOSS)                                          $      70,292     $   (989,768)    $   1,173,304
                                                           ==============    ==============   ==============



EARNINGS (LOSS) PER COMMON SHARE                           $          .01    $      (0.10)    $        0.12
                                                           ===============   ==============   ==============

EARNINGS (LOSS) PER COMMON SHARE--Assuming Dilution        $          .01    $      (0.10)    $        0.12
                                                           ===============   ==============   ==============

DIVIDENDS PAID PER COMMON SHARE                            $           -     $           -    $           -
                                                           ==============    ==============   ==============


</TABLE>





   The accompanying notes are an integral part of these financial statements.


                                       19

<PAGE>

<TABLE>
<CAPTION>

                            THE LEATHER FACTORY, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<S>                                                                             <C>         <C>              <C>
                                                                                1997              1996            1995
                                                                           --------------   ---------------  --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income (loss)                                                        $      70,292    $     (989,768)   $   1,173,304
  Adjustments to reconcile net income to net
   cash provided by (used in) operating activities-
     Depreciation and amortization                                                523,551           638,450         424,135
    (Gain) loss on sales of assets                                                46,950            (7,541)         (9,524)
     Deferred financing costs                                                     32,113           156,891               -
     Deferred income taxes                                                        16,845            13,479          (9,257)
     Other                                                                         1,150               785               -
     Net changes in operating assets and liabilities, net of effect of
      acquisitions:
       Accounts receivable-trade, net                                             82,422           814,870        (104,118)
       Inventory                                                                 457,618           241,843         328,316
       Income taxes                                                              252,488          (383,199)       (243,435)
       Other current assets                                                      157,610           130,683        (326,759)
       Accounts payable                                                            1,497          (458,368)       (104,939)
       Accrued expenses and other liabilities                                    (37,231)          (58,482)       (400,868)
                                                                           --------------   ---------------  --------------
     Total adjustments                                                         1,535,013         1,089,411        (446,449)
                                                                           --------------   ---------------  --------------

      Net cash provided by operating activities                                1,605,305            99,643         726,855
                                                                           --------------   ---------------  --------------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Purchases of property and equipment                                           (239,578)         (208,537)       (513,483)
  Proceeds from sales of assets                                                  257,306            10,444          17,746
  Cash paid for acquisitions, net of cash acquired                                     -          (300,000)     (5,232,389)
  Decrease in assets restricted for acquisitions                                       -                 -       5,040,656
  Other intangible costs                                                         (32,061)          (24,788)        (42,234)
                                                                           --------------   ---------------  --------------

      Net cash used in investing activities                                      (14,333)         (522,881)       (729,704)
                                                                           --------------   ---------------  --------------

CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from notes payable and long-term debt                               9,859,025         3,300,000       2,574,904
  Payments on notes payable and long-term debt                               (11,410,299)       (2,596,424)     (2,231,478)
  Increase in cash restricted for payment on revolving credit facility          (319,133)               -               -
  Payments received (purchase) of  notes receivable -
     secured by common stock                                                      11,688          (269,305)             -
  Securities acquisition loan to ESOP                                                  -                 -         (99,962)
  Deferred financing costs                                                      (149,949)                -        (165,709)
                                                                           --------------   ---------------  --------------

      Net cash provided by (used in) financing activities                     (2,008,668)          434,271          77,755
                                                                           --------------   ---------------  --------------

NET INCREASE (DECREASE) IN CASH                                                 (417,696)           11,033          74,906

CASH, beginning of year                                                          488,192           477,159         402,253
                                                                           --------------   ---------------  --------------

CASH, end of year                                                          $      70,496    $      488,192   $     477,159
                                                                           ==============   ===============  ==============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
  Interest paid during the year                                            $     749,472    $      793,373   $     763,848
  Income taxes paid during the year, net of (refunds)                            (38,101)           55,445       1,066,111



</TABLE>




   The accompanying notes are an integral part of these financial statements.


                                       20

<PAGE>


<TABLE>
<CAPTION>

                            THE LEATHER FACTORY, INC.
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

<S>                                                                              <C>          <C>           <C>         <C>


                                Common Stock
                                                                                     Notes
                           ------------------------                               receivable   Cumulative
                             Number       Par          Paid-in      Retained     - secured by  translation    Unearned
                           of shares     value         capital      earnings     common stock  adjustments  ESOP shares   Total
                           ----------- -----------   ------------  ------------  ------------- ------------ ----------- -----------

BALANCE, December 31, 1994   9,853,161 $  23,648     $ 4,139,614   $ 4,280,741   $         -   $        -   $(226,222)  $ 8,217,781


Stock issuance costs                 -         -          (8,818)            -             -            -          -        (8,818)


Securities acquisition
 loan to ESOP                        -         -               -             -             -            -     (99,962)      (99,962)


Net income                           -         -               -     1,173,304             -            -           -     1,173,304
                             --------- ---------    ------------  ------------   ------------ ------------  ----------- -----------

BALANCE, December 31, 1995   9,853,161    23,648       4,130,796     5,454,045             -            -    (326,184)    9,282,305

Notes receivable - secured
   by common stock                   -         -               -             -      (269,305)           -           -      (269,305)

Translation adjustment               -         -               -             -             -         (295)          -          (295)

Net loss                             -         -               -      (989,768)            -            -           -      (989,768)
                             --------- -----------   ------------  ------------  ------------ ------------   ---------- -----------

BALANCE, December 31, 1996   9,853,161    23,648       4,130,796     4,464,277       (269,305)        (295)  (326,184)    8,022,937

Payments on notes receivable -
 secured by common stock             -         -               -             -         11,688           -           -        11,688

Allocation of suspended ESOP
shares committed to be released      -         -         (45,881)            -              -           -      52,333         6,452

Warrants issued to acquire
100,000 shares of common stock       -         -          35,000             -              -           -           -        35,000

Translation adjustment               -         -               -             -              -     (13,723)          -       (13,723)

Net income                           -         -               -        70,292              -           -           -        70,292
                             --------- -----------   ------------  ------------  ------------- ------------ -----------  ----------

BALANCE, December 31, 1997   9,853,161 $  23,648    $  4,119,915   $ 4,534,569   $   (257,617)   $(14,018)  $(273,851)   $8,132,646
                             ========= ===========   ============  ===========   ============= ============ ===========  ==========

</TABLE>





   The accompanying notes are an integral part of these financial statements.



                                       21

<PAGE>


                            THE LEATHER FACTORY, INC.
                              NOTES TO CONSOLIDATED
                              FINANCIAL STATEMENTS

                        DECEMBER 31, 1997, 1996 AND 1995


1.  ORGANIZATION AND NATURE OF OPERATIONS

The Leather Factory,  Inc. and subsidiaries (the "Company")  operations  include
the  manufacture,   distribution,   importation,  and  exportation  of  leather,
leatherworking  tools,  buckles  and other belt  supplies,  shoe care and repair
supplies,  leather dyes and finishes,  adornments for belts, bags, and garments,
saddle and tack  hardware,  and  do-it-yourself  kits.  The Company  through its
subsidiary,  Roberts,  Cushman  &  Company,  Inc.,  is also a  manufacturer  and
distributor of hat trims and small  finished  leather goods such as cigar cases,
picture frames,  wallets, and western accessories.  As of December 31, 1997, the
Company  had 22  sales/distribution  units in 17 states  and  Canada,  including
Arizona,  California,  Colorado,  Florida,  Iowa, Kansas,  Louisiana,  Michigan,
Missouri,  New Mexico, North Carolina,  Ohio,  Pennsylvania,  Tennessee,  Texas,
Utah,  Washington,  and  Winnipeg.  The  Company  also has  light  manufacturing
facilities In Fort Worth, Texas and New York, New York.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation

The consolidated  financial  statements  include the accounts of the Company and
its  subsidiaries,  all of  which  are  wholly-owned.  Significant  intercompany
accounts and transactions have been eliminated in consolidation.

Inventory

The Company's  inventory is valued at the lower of first-in,  first-out  cost or
market and consists of the following at December 31:

                                                   1997              1996
                                                ----------        ----------
  Finished goods held for sale                  $5,833,002        $6,516,517
  Raw materials and work in process              1,446,700         1,220,803
                                                ----------        ----------
                                                $7,279,702        $7,737,320
                                                ==========        ==========

Property and Equipment

Property and  equipment are stated at cost.  Expenditures  for  maintenance  and
repairs are charged to expense when incurred. The cost of assets retired or sold
and the  related  amounts  of  accumulated  depreciation  are  removed  from the
accounts,  and any  gain  or  loss  is  included  in the  statement  of  income.
Depreciation  is determined  using the  straight-line  method over the estimated
useful lives as follows:

          Building                           30 years
          Leasehold improvements             5-7 years
          Equipment                          5-10 years
          Furniture and fixtures             5-7 years
          Automobiles                        5 years

Depreciation  expense was  $303,867;  $277,994;  and 224,364 for the years ended
December 31, 1997, 1996 and 1995, respectively.

Goodwill

Goodwill  resulting  from  business  purchases  accounted for using the purchase
method of accounting is being amortized on a straight-line  basis over estimated
useful lives ranging from ten to forty years.

Acquisitions to date have not involved any significant  long-lived  assets other
than goodwill.  Accordingly,  the Company evaluates such goodwill for impairment
in accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 17,  "Intangible  Assets."  During  1996,  the Company  determined  that the
goodwill  associated with the  acquisition of Hi-Line Leather and  Manufacturing
Co.,  Inc.  in 1994 was  impaired,  and should be  reduced  by fifty  percent or
approximately  $142,000.  This  conclusion  was reached due to the fact that the
customer base acquired in the purchase  transaction had declined  substantially,
and the  operating  results of the location  since the  acquisition  had not met
expectations.  Based upon the  assessment of possible  future cash flows and the
fact that business  conditions could improve,  management believes the remaining
goodwill is recoverable and the amortization period remains appropriate.


                                       22

<PAGE>


Amortization expense of $219,684 in 1997; $360,456 in 1996; and $199,771 in 1995
was recorded in operating expenses including the above write-down.

Advertising Costs

With the exception of catalog costs,  advertising cost are expensed as incurred.
Catalog costs are capitalized and expensed over the estimated useful life of the
particular  catalog in question,  which is typically  twelve to fifteen  months.
Such capitalized  costs are included in other current assets and totaled $39,350
and  $203,755 at December  31, 1997 and 1996,  respectively.  Total  advertising
expense was $1,002,623 in 1997; $1,089,716 in 1996; and $976,126 in 1995.

Revenue Recognition

Sales are recorded when goods are shipped to customers.

Income Taxes

Deferred  income taxes result from temporary  differences in the basis of assets
and liabilities reported for financial statement and income tax purposes.

Earnings Per Share

In 1997, the Financial  Accounting  Standards Board ("FASB") issued Statement of
Financial  Accounting  Standards  ("SFAS") No. 128, Earnings per Share. SFAS No.
128 replaced the  calculation  of primary and fully  diluted  earnings per share
with basic and diluted  earnings per share.  Unlike primary  earnings per share,
basic earnings per share excludes any dilutive effects of options,  warrants and
convertible  securities.  Diluted  earnings  per  share is very  similar  to the
previously  reported  fully diluted  earnings per share.  All earnings per share
amounts  for all  periods  have been  presented  to  conform  to  Statement  128
requirements. The adoption of Statement 128 had no effect on previously reported
amounts as the effects of outstanding  options were  antidilutive  for all prior
periods  presented.  Unearned shares held by the Employees' Stock Ownership Plan
are deemed not to be outstanding for earnings per share calculations.

Accounting Estimates

The consolidated  financial statements include estimates and assumptions made by
management  that  affect the  reported  amounts of assets and  liabilities,  the
reported  amounts of revenues  and  expenses and the  disclosure  of  contingent
assets and liabilities.
Actual results could differ from those estimates.

Long-Lived Assets

The FASB has issued SFAS No. 121,  Accounting  for the  Impairment of Long-Lived
Assets and for  Long-Lived  Assets to be Disposed of. SFAS No. 121 requires that
long-lived  assets and certain  identifiable  intangible  assets be reviewed for
impairment whenever events indicate that the carrying amount of an asset may not
be recoverable.  The Company has determined that as of December 31, 1997, it has
no long-lived assets that meet the impairment criteria of SFAS No. 121.

Stock-Based Compensation

SFAS No. 123,  Accounting for Stock-Based  Compensation,  establishes  financial
accounting and reporting standards for stock-based employee  compensation plans.
As permitted by SFAS 123, the Company has elected to continue to use  Accounting
Principles  Board  Opinion No. 25,  "Accounting  for Stock Issued to  Employees"
("APB 25") and  related  Interpretations,  in  accounting  for its stock  option
plans.

Impact of new accounting standards

In June 1997, the FASB issued SFAS No. 130, Reporting  Comprehensive Income, and
SFAS  No.  131,   Disclosures  about  Segments  of  an  Enterprise  and  Related
Information. SFAS No. 130 requires that an enterprise report, by major component
and as a single total,  the change in its equity during the period from nonowner
sources, and SFAS No. 131 establishes annual and interim reporting  requirements
for an  enterprise's  operating  segments  and  related  disclosures  about  its
products  and  services,  geographical  areas  in which it  operates  and  major
customers.  Both  statements  are  effective  for fiscal years  beginning  after
December  15,  1997,  with  earlier  application  permitted.  Adoption  of these
statements  is not  expected to  materially  impact the  Company's  consolidated
financial position or statements of income, stockholders' equity and cash flows.
Effects of the  adoption of these  statements  will  primarily be limited to the
form and content of the Company's disclosures.

                                       23

<PAGE>


3.  NOTES PAYABLE AND LONG-TERM DEBT

On November 21,  1997,  the Company  entered into a Loan and Security  Agreement
with FINOVA Capital Corporation  ("FINOVA"),  pursuant to which FINOVA agreed to
provide a credit  facility of up to  $9,136,000 in senior debt (the "Senior Debt
Facility").  The Senior Debt  Facility  has a two-year  term and is made up of a
revolving  credit facility and three term notes.  One of the notes (Term Note B)
in the original  principal  amount of $236,000 was  satisfied in its entirety on
December  15,  1997 with the net  proceeds  from the sale of the real  estate in
Tampa, Florida.

Simultaneously  with the closing of the Senior Debt  Facility  the Company  also
issued to The  Schlinger  Foundation at face value  $1,000,000  in  subordinated
convertible debt (the "Subordinated Debenture").

Proceeds of the closing of the Senior Debt Facility in the amount of $6,417,563,
together with the $1,000,000 of proceeds from the Subordinated  Debenture,  were
used to pay all  amounts  due and owing by the  Company  pursuant  to the Second
Restated Loan Agreement,  as amended, by and between the Company and NationsBank
of Texas,  N.A.  ("NationsBank").  At closing,  the Company's  revolving line of
credit and term loan  facility  with  NationsBank  in the  principal  amounts of
$5,125,000 and $2,200,000,  respectively,  were satisfied in their entirety. The
Company used the remaining proceeds to pay certain closing and financing costs.

At  December  31,  1997 and  1996,  the  amounts  outstanding  under  the  above
agreements  and  other  notes  payable  and  long-term  debt  consisted  of  the
following:

<TABLE>
<S>                                                                                         <C>           <C>
                                                                                            1997          1996
                                                                                            ----          ----
Loan & Security  Agreement with FINOVA -- collateralized by all of the assets of
the  Company as well as a pledge of  3,000,000  shares of the  Company's  common
stock,  par value  $.0024  ("Common  Stock"),  collectively  owned by two of the
Company's executive officers, payable as follows:

     Promissory  Note  (Revolving  Credit  Loan) dated  November 21, 1997 in the
     maximum  principal  amount of $7,000,000  with  revolving  features as more
     fully described below -- interest due monthly at prime plus 1% (9.5% at
     December 31, 1997); matures December 1, 1999                                       $   4,030,519    $    -


     Promissory  Note (Term Loan A) dated  November  21, 1997 in the  original
     principal  amount of $400,000 -- $6,667 monthly  principal  payments plus
     interest  at prime  plus  .75%  (9.25% at  December  31,  1997);  matures
     December 1, 1999                                                                         400,000          -

     Promissory  Note (Term Loan C) dated  November  21, 1997 in the  original
     principal  amount of $1,500,000  -- $25,000  monthly  principal  payments
     plus  interest at prime plus 3% (11.5% at  December  31,  1997);  matures
     December 1, 1999                                                                       1,500,000          -

     *Short-term  note  payable for facility  fee -- monthly  installments  of
     $5,833; matures November 1, 1998                                                          64,167          -

*Unsecured  short-term  note payable to third party for fees in connection  with
the closing of the Senior Debt facility -- monthly installments of $14,000;
matures October 1, 1998                                                                       140,000          -

Loan Agreement with NationsBank -- collateralized  by inventory,  trade accounts
receivable, equipment, fixtures and real estate, payable as follows:

     Promissory  Note  (Term  Loan)  dated  December  28,  1994 in the  original
     principal  amount of  $5,000,000 -- $250,000  principal due quarterly  with
     monthly  interest  payments at prime plus 1.5% (9.75% at December 31, 1996)
     until maturity at April 30, 1997; maturity was extended to
     November 30, 1997 with the rate increased to prime plus 2%                                     -     3,000,000

     Promissory Note (Working Capital Line of Credit)  originally dated July 24,
     1995 in the maximum  principal amount of $6,500,000 -- interest due monthly
     at prime plus 1.5 % (9.75% at December  31,  1996) until  maturity at April
     30, 1997; maturity was extended to November 30, 1997 with the
     rate increased to prime plus 2%                                                                -     5,500,000

                                       24

<PAGE>


Subordinated Debenture in the original principal amount of $1,000,000; partially
convertible;  secured by a pledge of 2,666,666  shares of the  Company's  Common
Stock owned by another executive officer -- monthly interest payments at 13%;
matures December 1, 1999;                                                                   1,000,000         -

Unsecured note payable  created in connection with the acquisition of the assets
of The Leather Warehouse in 1994 -- $4,424 payments of principal and interest
due monthly at prime (8.5% at December 31, 1997); matures on April 1, 1998                     17,388       66,744

Capital  Leases  secured by computer  equipment -- total  monthly  principal and
interest payments of $2,599 at a rate of approximately 13.5%; maturing in
February through August of 2002                                                               101,396         -

                                                                                        -------------   ----------
                                                                                            7,253,470    8,566,744

Less - Current maturities (see below)                                                       4,650,742    8,549,366
                                                                                        -------------   ----------
                                                                                        $   2,602,728   $   17,378
                                                                                        =============   ==========
</TABLE>

The current  portion of long-term  debt for 1997  includes the FINOVA  Revolving
Credit  Loan of  $4,030,519  although  this  obligation  does not  mature  until
December  1,  1999.  The  classification  of  this  debt  was  attributed  to an
accounting rule that requires a revolving  credit agreement that includes both a
subjective  acceleration  clause and a requirement  to maintain an  arrangement,
whereby cash collections from the borrower's  customers directly reduce the debt
outstanding,  to be classified as a short-term  obligation (Emerging Issues Task
Force Issue 95-22).  A covenant of the Senior Debt Facility is that  collections
from customers are to be deposited into a cash collateral  account that directly
pays down the Revolving  Credit Loan. The balance in this account  comprises the
restricted cash on the Company's balance sheet.  Because of this arrangement and
the fact that the debt agreement contains a clause that would allow acceleration
of payment of the debt in case of a "material  adverse  change",  the above rule
applies.  Management does not believe that any such  acceleration will occur and
that the Revolving Credit Loan will provide long-term liquidity.

In addition to the above  obligations,  the Company had  outstanding  letters of
credit for inventory  purchase  commitments  with terms ranging from sight to 90
days.  As of December 31, 1997 and 1996,  $260,089 and  $273,065,  respectively,
were outstanding on these letters of credit.

Pursuant to the Loan and Security  Agreement with FINOVA,  the overall  combined
limit for borrowings under the Revolving Credit Loan and outstanding  balance on
letters of credit is $7,000,000.  Of the overall  $7,000,000  limit,  letters of
credit  cannot  exceed  $1,000,000.  The unused  portion of the letter of credit
limit  can be  utilized  for  borrowings,  up to the  limits  imposed  for  said
indebtedness.  Total  borrowings  under this  arrangement  are also limited to a
certain  percentage of trade accounts  receivable  and inventory  reduced by the
outstanding  balance of letters of credit and any required reserves.  Additional
availability  at December  31,  1997,  under the  Revolving  Credit Loan and for
letters of credit was $377,831.

At any time before maturity of the  Subordinated  Debenture,  the holder may, at
its option,  satisfy 50% or $500,000 of the principal  amount by converting into
shares of the Company's Common Stock at $0.724 per share.

The terms of the Senior Debt  Facility and the  Subordinated  Debenture  contain
various  covenants  which among other  things  require the Company to maintain a
certain level of earnings before interest, taxes, depreciation and amortization,
limit capital expenditures,  and require the maintenance of certain debt service
coverage   ratios.   Other   covenants   prohibit  the  Company  from  incurring
indebtedness except as permitted by the terms of the Senior Debt Facility,  from
declaring or paying cash  dividends upon any of its stock and from entering into
any new business or making  material  changes in any of the  Company's  business
objectives, purposes or operations.

The Company's notes payable and long-term debt mature as follows (see discussion
above relative to classification of the Revolving Credit Loan):

                           1998              $  4,650,742
                           1999                 2,541,338
                           2000                    24,393
                           2001                    31,132
                           2002                     5,865
                                             ------------
                                             $  7,253,470
                                             ============

*The  short-term  notes for the fees  related to the  closing of the Senior Debt
Facility  were issued for services  rendered in the original  amount of $238,000
and constitute a non-monetary transaction.

                                       25

<PAGE>


4.  EMPLOYEE BENEFIT PLAN

The Company has an Employee Stock Ownership Plan (the "Plan") for employees with
at least one year of service (as defined by the Plan) and who have reached their
21st  birthday.  Under  the  Plan,  the  Company  makes  annual  cash  or  stock
contributions  to a trust  for the  benefit  of  eligible  employees.  The trust
invests in shares of the  Company's  common  stock.  The amount of the Company's
annual  contribution is  discretionary.  Benefits under the Plan are 100% vested
after  three  years  of  service  and are  payable  upon  death,  disability  or
retirement. Vested benefits are payable upon termination of employment.

The  Company  contributed  $50,910;  $27,500;  and  $133,378 in cash to the Plan
during  1997,  1996  and  1995,  respectively.   Of  the  1995  amount,  $33,416
represented a contribution,  while $99,962 represented a securities  acquisition
loan. During 1995, the Plan purchased 23,500 shares of Company stock on the open
market for $99,962.  In accordance with Statement of Position 93-6 ("SOP 93-6"),
"Employers Accounting for Employee Stock Ownership Plans," shares purchased with
loan  proceeds  have been  recorded as unearned  ESOP shares.  The unearned ESOP
share account is reduced by the cost of the shares when they are committed to be
released to  participants.  This occurs as payments  are made on the loans using
the  principal  and  interest  method and shares are  allocated  to  participant
accounts  based upon eligible  compensation  during the period that includes the
scheduled  payment.  During 1997,  10,369  shares were released and allocated to
participant  accounts.  Compensation  expense is measured using the average fair
market value of the shares when committed to be released. The Company recognized
compensation  expense  related to the Plan of $53,968;  $27,500;  and $33,416 in
1997, 1996 and 1995, respectively.

The  following  table  summarizes  the number of shares held by the Plan and the
market value as of December 31, 1997, 1996 and 1995:

                      No. of Shares                      Market Value
                      -------------                      ------------
                 1997      1996     1995         1997        1996         1995
                 -----     ----     ----         ----         ---         ----
   Allocated   652,609  681,547   725,605    $ 326,305   $ 554,098   $ 1,769,025
   Unearned     54,262   64,631    64,631       27,131      52,545       157,570
               --------------------------    -----------------------------------
     Total     706,871  746,178   790,236    $ 353,436   $ 606,643   $ 1,926,595
               ==========================    ===================================

The Company currently offers no postretirement or postemployment benefits to its
employees.

5.  INCOME TAXES

The provision for income taxes consists of the following:

                                          1997           1996         1995
                                          ----           ----         ----
Current provision (benefit):
                Federal               $  174,469   $  (282,917)  $  658,975
                State                     39,918       (47,098)     137,026
                                      ----------   -----------   ----------
                                         214,387      (330,015)     796,001
                                      ----------   -----------   ----------
Deferred provision (benefit):
                Federal                   14,185         11,351      (7,870)
                State                      2,660          2,128      (1,387)
                                      ----------   ------------  ----------
                                          16,845         13,479      (9,257)
                                      ----------   ------------  ----------
                                      $  231,232   $  (316,536)  $  786,744
                                      ==========   ===========   ==========



Deferred  taxes  relate  primarily  to  temporary  differences  in the  bases of
accounts receivable, inventory, property and equipment and accrued expenses.

The effective tax rate differs from the statutory rate as follows:


                                                        1997     1996     1995
                                                        ----     ----     ----
                 Statutory rate                          34%    (34%)     34%
                 State taxes                             10%     (3%)      4%
                 Non-deductible goodwill amortization    26%      10%      4%
                 Other                                    7%       3%    (2%)
                                                        ---------------------
                 Effective rate                          77%    (24%)     40%
                                                        ======================



                                       26


<PAGE>


6.  COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company's primary office facility and warehouse are leased under a five-year
lease  agreement  that  expires  in  March  2003.   Rental  agreements  for  the
sales/distribution  units expire on dates ranging from July 31, 1998 to December
31, 2003. The Company's  lease agreement for the  manufacturing  facility in New
York, New York, expires on September 30, 1998. Future minimum lease payments for
all noncancellable operating leases are as follows:

                              Year Ending December 31,

                    1998                             $    994,244
                    1999                                  742,224
                    2000                                  590,443
                    2001                                  486,891
                    2002                                  384,684
                    2003 and thereafter                   117,431
                                                     ------------
      Total future minimum lease payments            $  3,315,917
                                                     ============


Rent expense on all operating leases for the years ended December 31, 1997, 1996
and 1995, was $1,036,892; $1,008,458; and $928,433, respectively.

Litigation

The  Company  has  litigation  in  the  ordinary  course  of  its  business  and
operations. The Company does not expect the outcome of any current litigation to
have a material impact on its financial position and results of operations.

7.  MAJOR VENDORS

Two major vendors accounted for 17% and 8%, respectively,  of the Company's 1997
inventory purchases. These same vendors accounted for 16% and 10%, respectively,
of 1996 inventory purchases,  and 15% and 14%,  respectively,  of 1995 inventory
purchases.   Due  to  the  number  of  alternative  sources  of  supply,  it  is
management's  opinion  that  the  loss of  either  or both  of  these  principal
suppliers would not have a material impact on the operations of the Company.

8.  EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per
share:
<TABLE>

<S>                                                                             <C>         <C>

                                                             1997              1996              1995
                                                        ----------------  ----------------  ----------------
Numerator:
     Net income (loss)                                  $        70,292   $       (989,768) $     1,173,304
                                                        ----------------  ----------------  ----------------
     Numerator for basic and diluted
       earnings per share                                        70,292           (989,768)       1,173,304

Denominator:
     Denominator for basic earnings per share-
     weighted-average shares                                  9,789,358          9,788,530        9,789,468

Effect of dilutive securities:
     Employee stock options                                          25                  -                 -
     Warrants                                                     2,182                  -                 -
                                                        ----------------  ----------------  ----------------
Dilutive potential common shares                                   2,207                 -                 -
                                                        ----------------  ----------------  ----------------

     Denominator for diluted earnings per share -
     adjusted weighted-average shares and assumed
     conversions                                               9,791,565         9,788,530         9,789,468
                                                        ================  ================  ================

     Basic earnings per share                           $           0.01  $         (0.10)  $           0.12
                                                        ================  ================  ================

     Diluted earnings per share                         $           0.01  $         (0.10)  $           0.12
                                                        ================  ================  ================


</TABLE>


                                       27

<PAGE>
For  additional  disclosures  regarding  the  employee  stock  options  and  the
warrants,  see note 9. The majority of the options  outstanding  as discussed in
note 9 were not  included  in the  computation  of  diluted  earnings  per share
because the options' exercise price was greater than the average market price of
the common shares and, therefore, the effect would be antidilutive.

The 13%  convertible  debt  discussed  in note 3 above was not  included  in the
computation of diluted earnings per share because the interest cost (net of tax)
per  assumed  converted  share  was more than  basic  earnings  per  share  and,
therefore, the effect would be antidilutive.

On January 28, 1998,  the Company  granted  additional  options to acquire up to
150,000 shares of common stock under the 1995 Stock Option Plan for Officers and
Key Management Employees as discussed in note 9. The market price on the date of
grant was $0.50 per share which is less than the average market price in 1997 or
1995 and, therefore, would have been dilutive if outstanding in such periods. In
addition,  subsequent to year end,  options to acquire  100,000 shares under the
same plan were forfeited.

9.  STOCKHOLDERS' EQUITY

Stock Option Plans

The Company has outstanding  options to purchase its common stock under The 1995
Stock  Option  Plan  for  officers  and key  management  employees  and The 1995
Director  Non-qualified Stock Option Plan for non-employee  directors.  The plan
for  employees  provides for the granting of either  qualified  incentive  stock
options or non-qualified options at the discretion of the Compensation Committee
of the Board of  Directors.  Options are granted at the fair market value of the
underlying  common  stock at the date of  grant.  Employee  options  vest over a
five-year period while the director  options vest after six months.  All options
expire ten years from the date of grant and are  exerciseable  at any time after
vesting.  The Company has reserved 1,100,000 shares of common stock for issuance
under these plans,  and at December 31, 1997, 1996 and 1995, there were 534,000;
590,000; and 515,000;  respectively,  in un-optioned shares available for future
grants.

A summary of the Company's stock option activity and related information for the
years ended December 31, 1997, 1996 and 1995, is as follows:

<TABLE>
<S>                                                                             <C>         <C>         <C>

                                                 1997                     1996                     1995
                                       -----------------------     ----------------------   ----------------------
                                                     Weighted                  Weighted                 Weighted
                                                     Average                   Average                   Average
                                         Option      Exercise       Option     Exercise      Option     Exercise
                                         Shares       Price         Shares      Price        Shares       Price
                                       ------------ ----------    ----------- -----------   ----------  ----------
    Outstanding at January 1               510,000   $   2.653       585,000  $    3.063           -     $      -
    Granted *                              456,000       0.805       106,000       1.088      585,000       3.063
    Forfeited                                    -           -      (181,000)      3.063            -           -
    Exchanged *                          (400,000)       3.063             -           -            -           -
    Exercised                                    -           -             -           -            -           -
                                       ------------ -----------   ----------- -----------   ----------  ----------
    Outstanding at December 31             566,000   $   0.874       510,000  $    2.653      585,000   $   3.063
                                       ===========  ===========   =========== ==========    ==========  ==========
    Exercisable at end of year             190,000   $  0.908         84,000  $    3.063            -   $       -
                                       ============ ===========   =========== ===========   ==========  ==========
    Weighted-average fair value of
     options granted during year         $    0.31                 $    0.52                 $   1.45
                                       ============               ===========               ==========

* In 1997, options  originally granted in 1995 were canceled and reissued.  This
action was taken to provide  incentive  to and in order to retain the  Company's
key management  personnel in light of the severe decline in the market price for
the Company's common stock.

The  following  table  segregates  outstanding  options  into groups  based upon
exercise price ranges.

                                           Outstanding                               Exercisable
                               ------------------------------------    ---------------------------------------
                                             Weighted    Weighted                       Weighted    Weighted
                                              Average    Average                         Average     Average
                                  Option     Exercise    Maturity            Option     Exercise    Maturity
   Exercise Price Range           Shares       Price     (Years)             Shares       Price      (Years)
   --------------------
                               ------------  ---------- -----------       ------------  ----------  ----------
   $0.75 or Less                    31,000   $   0.700       9.75                   -   $       -          -
   More than $0.75 &
    Less Than $1.00                425,000       0.813       7.84             160,000       0.813       7.75
   More than $1.00                 110,000       1.159       8.79              30,000       1.417       8.67
                               ------------  ---------- -----------       ------------  ----------  ----------
                                   566,000   $   0.874       8.13             190,000   $   0.908       7.90
                               ============  ========== ===========       ============  ==========  ==========
</TABLE>
                                       28

<PAGE>

Pro forma information  regarding net income (loss) and earnings (loss) per share
is required by SFAS 123, and has been determined as if the Company had accounted
for its stock  options  under the fair  value  method.  The fair value for these
options  was  estimated  at the date of grant  using  the Black  Scholes  option
pricing  model  with  the  following  weighted-average  assumptions:   risk-free
interest  rates  of 6.64% in  1997;  6.72% in 1996 and  6.38% in 1995;  dividend
yields of 0% for all  years;  volatility  factors  of .550 for 1997 and .439 for
both 1996 and 1995;  and an expected  life of the valued  options of 5 years for
all years  other  than the  exchanged  options  reissued  in 1997  which have an
expected remaining life of 4 years.

Option  valuation  models  require the input of highly  subjective  assumptions,
including  the  expected  stock  price  volatility,  and  changes in these input
assumptions can materially affect the fair value estimate they produce.  Because
of this,  it is  management's  opinion that existing  models do not  necessarily
provide a reliable single measure of fair value for the Company's stock options.
For pro forma disclosures, the estimated fair values determined by the model are
being  amortized to expense on a  straight-line  basis over the options  vesting
period  as  adjusted  for  estimated   forfeitures.   The  Company's  pro  forma
information follows:

<TABLE>
<S>                                                                             <C>

                                                 1997              1996            1995
                                              ------------     ------------    ------------
Pro forma net income (loss)                   $ (76,117)       $(1,057,818)    $1,121,736


Pro forma earnings (loss) per common share    $    (.01)       $     (0.11)    $     0.11


Pro forma earnings (loss) per common share-
Assuming Dilution                             $    (.01)       $     (0.11)    $     0.11

</TABLE>

Warrants

In connection with the issuance of the Subordinated  Debenture discussed in note
3 above,  the Company issued  warrants to acquire up to 100,000 shares of Common
Stock at approximately $.54 per share to an unrelated  individual.  The warrants
may be  exercised at anytime  until  expiration  on November 21, 2002.  The fair
value for these  warrants  was  estimated  at the date of grant  using the Black
Scholes  option pricing model with the following  weighted-average  assumptions:
risk-free  interest rate of 6.5%;  dividend  yield of 0%;  volatility  factor of
 .550; and an expected life of 3 years.

Notes Receivable Secured by Common Stock

During 1996,  the Company  purchased  certain  notes from  NationsBank  that are
collateralized  by the  Company's  common  stock.  These notes  relate to shares
issued under the Company's 1993 Non-Qualified Incentive Stock Option Plan. These
notes, as renewed in 1997, are due from seven individuals including officers and
other members of management,  require monthly  payments,  and mature on December
31, 2000.

10.  ACQUISITIONS

On January 2,  1995,  the  Company  acquired  all of the issued and  outstanding
shares  of  capital  stock  of  Roberts,  Cushman  & Co.,  Inc.  ("Cushman"),  a
manufacturer  of  fancy  hat  trims  located  in  New  York,  New  York,  for an
approximate purchase price of $5,000,000. The purchase price was funded with the
proceeds of the  NationsBank  Term Loan  discussed in Note 3 above,  which along
with legal and other  acquisition  costs,  comprised  the  restricted  assets at
December 31, 1994.  The purchase was  accounted  for under the purchase  method,
effective January 1, 1995.

On January 31, 1995, the Company  acquired  certain assets of Gulf Coast Leather
Company,  Inc., a distributor  of shoe care and repair  supplies  located in New
Orleans,   Louisiana.  The  assets  purchased  included  inventory,   furniture,
fixtures,  equipment,  and rental and utility deposits. The total purchase price
was approximately  $91,869 which was funded with cash generated from operations.
The purchase was accounted for under the purchase method,  effective January 31,
1995.

On December  29,  1995,  the Company  acquired  certain  assets of B & J Leather
Company ("B & J") of Fort Worth,  Texas, which was engaged primarily in the sale
of leather and related  products  to the shoe  repair and care  industry.  These
assets, which included primarily salable inventory and intangible assets such as
vendor and customer  lists,  were valued at $100,094  which was funded with cash
generated from operations. The two principal shareholders of B & J were employed
by the Company subsequent to closing, with the business performed by B & J being
incorporated into the Company's  sales/distribution  unit located in Fort Worth,
Texas.  The purchase was  accounted  for under the  purchase  method,  effective
December 31, 1995.



                                       29

<PAGE>


On March 1, 1996, the Company acquired all of the issued and outstanding  shares
of capital stock of The Leather Factory of Canada,  Ltd., the Company's Canadian
distributor  located  in  Winnipeg,  Manitoba.  The  total  purchase  price  was
approximately  $300,000 which was funded with cash generated from operations and
the Company's  revolving credit  facility.  The purchase was accounted for under
the purchase method, effective March 1, 1996.


11.  FAIR VALUE OF FINANCIAL INSTRUMENTS

Cash and accounts receivable-trade
The carrying  amount  approximates  fair value because of the short  maturity of
those instruments.

Accounts payable
The carrying  amount  approximates  fair value because of the short  maturity of
those instruments.

Notes payable and long-term debt
With the  exception of the  Subordinated  Debenture,  the interest  rates on the
Company's  notes payable and long-term  debt fluctuate with changes in the prime
rate and are the  rates  currently  available  to the  Company;  therefore,  the
carrying amount of those instruments approximates their fair value.

The terms of the Subordinated  Debenture are the terms management believes would
be currently available to the Company for this type of financing; therefore, the
carrying amount approximates fair value.















                                       30


<PAGE>

<TABLE>

12.  QUARTERLY FINANCIAL DATA (UNAUDITED)

<S>                                                                              <C>           <C>
                                                  First           Second             Third           Fourth
               1997                             Quarter          Quarter           Quarter          Quarter
------------------------------------  ----------------------------------------------------------------------
Net sales                                    $ 6,459,892      $ 6,526,992       $ 6,353,582      $ 6,058,650
Gross profit                                   2,563,811        2,739,284         2,693,991        2,557,654
Net income (loss)                                (36,185)          87,858            92,439          (73,820)


Earnings (loss) per common share                      -              0.01              0.01            (0.01)
Earnings (loss) per common
share--assuming dilution                              -              0.01              0.01            (0.01)


Weighted average number of
common shares outstanding:
              Basic                            9,788,530        9,788,530         9,788,530        9,791,841
              Diluted                          9,788,530        9,788,530         9,788,630        9,800,569


                                                **First   (*)(**) Second           **Third         Fourth
               1996                             Quarter          Quarter           Quarter        Quarter
------------------------------------  ----------------------------------------------------------------------
Net sales                                   $  7,356,805      $ 7,155,218       $ 7,015,834      $ 6,725,775
Gross profit                                   2,894,664        2,337,962         2,777,628        2,553,405
Net income (loss)                                (21,994)        (810,963)           14,391         (171,202)

Earnings (loss) per common share                     -              (0.08)                -            (0.02)
Earnings (loss) per common
share--assuming dilution                             -              (0.08)                -            (0.02)


Weighted average number of
common shares outstanding:
              Basic                            9,788,530        9,788,530         9,788,530        9,788,530
              Diluted                          9,788,530        9,788,530         9,788,530        9,788,530

</TABLE>

* The second  quarter  results for 1996  include  several  items that affect the
comparability  to the other  quarters.  These  items  include the  write-off  of
deferred  costs  related to financing  commitments  that  expired,  the goodwill
write-down,  the write-off of a large bad debt due to a customer bankruptcy, and
a minimum royalty accrual and inventory write-off due to a licensing  agreement.
The aggregate amount of these costs were approximately $560,000.

** The results for the first through the third quarters of 1996 were affected by
excessive labor, production,  travel and legal cost related to the labor dispute
at the  Company's  New York  facility  that  affect  comparability  to the other
quarters.  The labor dispute was settled on favorable  terms in October of 1996.
The aggregate amount of these costs were approximately $475,000.


                                       31



<PAGE>



                            THE LEATHER FACTORY, INC.
          SCHEDULE II --VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
                     Years Ended December 31, 1997 and 1996




     ALLOWANCE FOR DOUBTFUL ACCOUNTS
                                                             1997        1996
                                                        ---------    ---------
        Balance at beginning of year                    $  54,000     $ 39,000

            Additions (reductions) charged to income       (4,000)     229,000

            Balances written off, net of recoveries       (22,000)    (214,000)
                                                        ---------     --------

        Balance at end of year                          $  28,000     $ 54,000
                                                        =========     ========














                                       32



<PAGE>



                         REPORT OF INDEPENDENT AUDITORS



The Board of Directors
The Leather Factory, Inc.

We have  audited the  accompanying  consolidated  balance  sheets of The Leather
Factory,  Inc. as of December  31, 1997 and 1996,  and the related  consolidated
statements of income,  stockholders'  equity,  and cash flows for the years then
ended. Our audit also included the financial  statement  schedule referred to in
the  index at Item  14(a).  These  financial  statements  and  schedule  are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements and schedule based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all  material  respects,  the  consolidated  financial  position  of The Leather
Factory, Inc. at December 31, 1997 and 1996, and the consolidated results of its
operations  and its cash  flows for the years then  ended,  in  conformity  with
generally  accepted  accounting  principles.  Also, in our opinion,  the related
financial statement schedule, when considered in relation to the basic financial
statements  taken as a whole,  presents  fairly  in all  material  respects  the
information set forth therein.


/s/ ERNST & YOUNG LLP


Fort Worth, Texas
March 4, 1998








                                       33







<PAGE>




                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



TO THE STOCKHOLDERS OF
THE LEATHER FACTORY, INC.:

We  have   audited  the   accompanying   consolidated   statements   of  income,
stockholders'  equity,  and cash flow of The Leather  Factory,  Inc. (a Delaware
corporation)  and  subsidiaries  for the year ended  December  31,  1995.  These
financial  statements are the  responsibility of the Company's  management.  Our
responsibility  is to express an opinion on these financial  statements based on
our audit.

We conducted our audit in accordance with generally accepted auditing standards.
Those standards  require that we plan and perform the audit to obtain reasonable
assurance   about  whether  the  financial   statements  are  free  of  material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material  respects,  The Leather Factory,  Inc. and subsidiaries  results of
operations  and their  cash  flows for the year  ended  December  31,  1995,  in
conformity with generally accepted accounting principles.


/s/ ARTHUR ANDERSEN LLP

Fort Worth, Texas
February 16, 1996












                                       34




<PAGE>



                                    PART III


Item 10.  Directors and Executive Officers of the Registrant.

     Information  required  by this item is  incorporated  by  reference  to the
material  appearing  under the heading  "Election of Directors"  and  "Executive
Officers of the Company" in the Proxy  Statement for the 1998 Annual  Meeting of
Stockholders.

Item 11.  Executive Compensation.

     Information  required  by this item is  incorporated  by  reference  to the
material  appearing  under the  heading  "Executive  Compensation"  in the Proxy
Statement for the 1998 Annual Meeting of Stockholders.

Item 12.  Security Ownership of Certain Beneficial Owners and Management.

     Information  required  by this item is  incorporated  by  reference  to the
material  appearing under the heading "Security  Ownership of Certain Beneficial
Owners and Management" and "Certain Transactions" in the Proxy Statement for the
1998 Annual Meeting of Stockholders.

Item 13.  Certain Relationships and Related Transactions.

     Information  required  by this item is  incorporated  by  reference  to the
material  appearing  under  the  heading  "Certain  Transactions"  in the  Proxy
Statement for the 1998 Annual Meeting of Stockholders.


                                     PART IV


Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K.

     (a) 1. Financial statements and financial statement schedules

     The financial  statements and schedule listed in the accompanying  index to
the  consolidated  financial  statements  at  Item 8 are  filed  as part of this
Report.

         2. Exhibits:

     The exhibits listed on the accompanying  Exhibit Index,  which  immediately
precedes such exhibits,  are filed or  incorporated by reference as part of this
Report and such Exhibit Index.

     (b) Reports on Form 8-K

         None.



                                       35


<PAGE>


                                   SIGNATURES



     In accordance  with Section 13 or 15(d) of the  Securities  Exchange Act of
1934,  the  Company  caused  this  Report  to be  signed  on its  behalf  by the
undersigned, thereunto duly authorized.

                                            THE LEATHER FACTORY, INC.
                                           (Registrant)


Date:         March 27, 1998               /s/ Wray Thompson
                                           --------------------------------
                                           Wray Thompson
                                           Chairman of the Board, President,
                                           and Chief Executive Officer

         In accordance with the Securities Exchange Act of 1934, this Report has
been signed below by the  following  persons on behalf of the Company and in the
capacities and on the dates indicated.

     Signature                  Title                            Date
     ---------                  -----                            ----

/s/ Anthony C. Morton        Chief Financial Officer,          March 27, 1998
---------------------        Treasurer and Director
Anthony C. Morton            (Chief Accounting Officer)


/s/ Wray Thompson            Chairman of the Board             March 27, 1998
---------------------
Wray Thompson


/s/ Ronald C. Morgan         Director                          March 27, 1998
---------------------
Ronald C. Morgan


/s/ Robin L. Morgan          Director                          March 27, 1998
---------------------
Robin L. Morgan


/s/ William M. Warren        Director                          March 27, 1998
---------------------
William M. Warren


/s/ H. W. Markwardt          Director                          March 27, 1998
---------------------
H. W. Markwardt



                                       36

<PAGE>
                   THE LEATHER FACTORY, INC. AND SUBSIDIARIES
                                  EXHIBIT INDEX

       Exhibit                        Description
        Number                        -----------
       -------
          3.1     Certificate of  Incorporation  of The Leather  Factory,  Inc.,
                  filed as Exhibit  3.1 to the  Registration  Statement  on Form
                  SB-2  of  The  Leather  Factory,  Inc.  (Commission  File  No.
                  33-81132) filed with the Securities and Exchange Commission on
                  July 5, 1994, and incorporated by reference herein.

          3.2     Bylaws of The Leather  Factory,  Inc., filed as Exhibit 3.2 to
                  the  Registration  Statement  on  Form  SB-2  of  The  Leather
                  Factory,  Inc.  (Commission  File No. 33-81132) filed with the
                  Securities  and  Exchange  Commission  on  July 5,  1994,  and
                  incorporated by reference herein.

          4.1     Sixth Amendment to Second Restated Loan Agreement effective as
                  of April 30, 1997, by and between The Leather Factory, Inc., a
                  Delaware Corporation, and NationsBank of Texas, N.A., filed as
                  Exhibit  4.14 to the  Quarterly  Report  on  Form  10-Q of The
                  Leather Factory, Inc. (Commission File No. 1-12368) filed with
                  the  Securities  and Exchange  Commission on May 15, 1997, and
                  incorporated by reference herein.

          4.2     Forbearance  Agreement effective as of August 31, 1997, by and
                  between The Leather Factory, Inc., a Delaware Corporation, and
                  NationsBank  of  Texas,  N.A.,  filed as  Exhibit  4.15 to the
                  Quarterly  Report on Form 10-Q of The  Leather  Factory,  Inc.
                  (Commission  File No.  1-12368)  filed with the Securities and
                  Exchange  Commission on November 14, 1997, and incorporated by
                  reference herein.

          4.3     Loan and Security  Agreement  dated  November 21, 1997, by and
                  between The Leather Factory, Inc., a Delaware corporation, The
                  Leather  Factory,  Inc.,  a  Texas  corporation,  The  Leather
                  Factory,  Inc.,  an  Arizona  corporation,  Hi-Line  Leather &
                  Manufacturing  Company,  a  California  corporation,  Roberts,
                  Cushman & Company,  Inc., a New York  corporation,  and FINOVA
                  Capital  Corporation,  filed  as  Exhibit  4.1 to the  Current
                  Report on Form 8-K of The Leather  Factory,  Inc.  (Commission
                  File No.  1-12368)  filed  with the  Securities  and  Exchange
                  Commission on February 6, 1998, and  incorporated by reference
                  herein.

          4.4     Revolving  Note  (Revolving  Credit  Loan) dated  November 21,
                  1997, in the principal  amount of  $7,000,000,  payable to the
                  order of FINOVA Capital Corporation, which matures December 1,
                  1999 filed as Exhibit 4.2 to the Current Report on Form 8-K of
                  The Leather Factory,  Inc. (Commission File No. 1-12368) filed
                  with the  Securities  and Exchange  Commission  on February 6,
                  1998, and incorporated by reference herein.

          4.5     Term Loan A Note (Term Loan A) dated November 21, 1997, in the
                  principal  amount of $400,000,  payable to the order of FINOVA
                  Capital  Corporation,  which matures December 1, 1999 filed as
                  Exhibit 4.3 to the  Current  Report on Form 8-K of The Leather
                  Factory,  Inc.  (Commission  File No.  1-12368) filed with the
                  Securities  and Exchange  Commission on February 6, 1998,  and
                  incorporated by reference herein.

          4.6     Term Loan B Note (Term Loan B) dated November 21, 1997, in the
                  principal  amount of $236,000,  payable to the order of FINOVA
                  Capital  Corporation,  which matures December 1, 1999 filed as
                  Exhibit 4.4 to the  Current  Report on Form 8-K of The Leather
                  Factory,  Inc.  (Commission  File No.  1-12368) filed with the
                  Securities  and Exchange  Commission on February 6, 1998,  and
                  incorporated by reference herein.

          4.7     Term Loan C Note (Term Loan C) dated November 21, 1997, in the
                  principal amount of $1,500,000, payable to the order of FINOVA
                  Capital  Corporation,  which matures December 1, 1999 filed as
                  Exhibit 4.5 to the  Current  Report on Form 8-K of The Leather
                  Factory,  Inc.  (Commission  File No.  1-12368) filed with the
                  Securities  and Exchange  Commission on February 6, 1998,  and
                  incorporated by reference herein.

          4.8     Subordination  Agreement  dated  November  21,  1997,  by  and
                  between FINOVA Capital Corporation,  The Schlinger Foundation,
                  The Leather Factory, Inc., a Delaware corporation, The Leather
                  Factory, Inc., a Texas corporation, The Leather Factory, Inc.,
                  an  Arizona  corporation,   Hi-Line  Leather  &  Manufacturing
                  Company,  a California  corporation,  and  Roberts,  Cushman &
                  Company,  Inc., a New York corporation filed as Exhibit 4.6 to
                  the Current  Report on Form 8-K of The Leather  Factory,  Inc.
                  (Commission  File No.  1-12368)  filed with the Securities and
                  Exchange  Commission on February 6, 1998, and  incorporated by
                  reference herein.

                                       37

<PAGE>


                   THE LEATHER FACTORY, INC. AND SUBSIDIARIES
                                  EXHIBIT INDEX
                                   (CONTINUED)


     Exhibit                          Description
     Number                           -----------
     -------
       4.9        Pledge  Agreement  dated  November  21,  1997,  by and between
                  Ronald  C.  Morgan  and Robin L.  Morgan  and  FINOVA  Capital
                  Corporation filed as Exhibit 4.7 to the Current Report on Form
                  8-K of The Leather Factory, Inc. (Commission File No. 1-12368)
                  filed with the Securities and Exchange  Commission on February
                  6, 1998, and incorporated by reference herein.

      4.10        Patent  Security  Agreement  dated  November 21, 1997,  by and
                  between The Leather Factory, Inc., a Delaware corporation, The
                  Leather  Factory,  Inc.,  a  Texas  corporation,  The  Leather
                  Factory,  Inc.,  an  Arizona  corporation,  Hi-Line  Leather &
                  Manufacturing  Company,  a  California  corporation,  Roberts,
                  Cushman & Company,  Inc., a New York  corporation,  and FINOVA
                  Capital Corporation filed as Exhibit 4.8 to the Current Report
                  on Form 8-K of The Leather Factory,  Inc. (Commission File No.
                  1-12368) filed with the Securities and Exchange  Commission on
                  February 6, 1998, and incorporated by reference herein.

      4.11        Trademark  Security  Agreement dated November 21, 1997, by and
                  between The Leather Factory, Inc., a Delaware corporation, The
                  Leather  Factory,  Inc.,  a  Texas  corporation,  The  Leather
                  Factory,  Inc.,  an  Arizona  corporation,  Hi-Line  Leather &
                  Manufacturing  Company,  a  California  corporation,  Roberts,
                  Cushman & Company,  Inc., a New York  corporation,  and FINOVA
                  Capital Corporation filed as Exhibit 4.9 to the Current Report
                  on Form 8-K of The Leather Factory,  Inc. (Commission File No.
                  1-12368) filed with the Securities and Exchange  Commission on
                  February 6, 1998, and incorporated by reference herein.

      4.12        Copyright  Security  Agreement dated November 21, 1997, by and
                  between The Leather Factory, Inc., a Delaware corporation, The
                  Leather  Factory,  Inc.,  a  Texas  corporation,  The  Leather
                  Factory,  Inc.,  an  Arizona  corporation,  Hi-Line  Leather &
                  Manufacturing  Company,  a  California  corporation,  Roberts,
                  Cushman & Company,  Inc., a New York  corporation,  and FINOVA
                  Capital  Corporation  filed  as  Exhibit  4.10 to the  Current
                  Report on Form 8-K of The Leather  Factory,  Inc.  (Commission
                  File No.  1-12368)  filed  with the  Securities  and  Exchange
                  Commission on February 6, 1998, and  incorporated by reference
                  herein.

      4.13        Promissory Note  (Subordinated  Debenture)  dated November 14,
                  1997, in the principal  amount of  $1,000,000,  payable to the
                  order of The Schlinger  Foundation,  which matures December 1,
                  1999 filed as Exhibit  4.11 to the Current  Report on Form 8-K
                  of The Leather  Factory,  Inc.  (Commission  File No. 1-12368)
                  filed with the Securities and Exchange  Commission on February
                  6, 1998, and incorporated by reference herein.

      4.14        Pledge and Security  Agreement dated November 14, 1997, by and
                  between The Schlinger  Foundation  and J. Wray  Thompson,  Sr.
                  filed as Exhibit 4.12 to the Current Report on Form 8-K of The
                  Leather Factory, Inc. (Commission File No. 1-12368) filed with
                  the  Securities  and Exchange  Commission on February 6, 1998,
                  and incorporated by reference herein.

      21.1        Subsidiaries of the Company,  filed as Exhibit No. 22.1 to the
                  1995 Annual Report on Form 10-KSB of The Leather Factory, Inc.
                  (Commission File No.  1-12368),  filed with the Securities and
                  Exchange Commission on March 28, 1996, and incorporated herein
                  by reference.

      *23.1       Consent of Ernst & Young LLP dated March 24, 1998.

      *23.2       Consent of Arthur Andersen LLP dated March 24, 1998.

      *27.1       Financial Data Schedule
  ------------
*Filed herewith.



                                       38


<PAGE>
























                                  EXHIBIT 23.1


























                                       39


<PAGE>









                         CONSENT OF INDEPENDENT AUDITORS



We consent to the incorporation by reference in the Registration Statement (Form
S-8 No.  33-81214)  pertaining to the Employee Stock Ownership Plan and Trust of
The  Leather  Factory,  Inc.  and  the  Registration  Statement  (Form  S-8  No.
333-07147) pertaining to the 1995 Stock Option Plan of The Leather Factory, Inc.
of our report dated March 4, 1998,  with respect to the  consolidated  financial
statements  and  schedule of The Leather  Factory,  Inc.  included in the Annual
Report (Form 10-K) for the year ended December 31, 1997.



/s/ ERNST & YOUNG LLP


Fort Worth, Texas
March 24, 1998


















                                       40


<PAGE>























                                  EXHIBIT 23.2






























                                       41



<PAGE>




                    CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS



As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-K, into the Company's  previously filed Form S-8
Registration Statements on File Nos. 33-81214 and 333-07147.



/s/ ARTHUR ANDERSEN LLP


Fort Worth, Texas
March 24, 1998












                                       42



<PAGE>















                                  EXHIBIT 27.1























                                       43