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



                                  FORM 10-KSB


(Mark One)

[X]                 ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF
                      THE SECURITIES EXCHANGE ACT OF 1934




[_]              TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF
                      THE SECURITIES EXCHANGE ACT OF 1934



          For the transition period from ___________________________ to
                          __________________________.


FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997     COMMISSION FILE NUMBER 000-21887


                              CD WAREHOUSE, INC.
                              ------------------
            (Exact name of registrant as specified in its charter)


            DELAWARE                                     73-1504999
            --------                                     ----------
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
 incorporation or organization)


1204 SOVEREIGN ROW, OKLAHOMA CITY, OKLAHOMA                        73108
-------------------------------------------                        -----
 (Address of principal executive offices)                        (Zip Code)


      Registrant's telephone number, including area code: (405) 949-2422
 
Securities registered pursuant to Section 12(b) of the Act:  NONE

Securities registered pursuant to Section 12(g) of the Act:  COMMON STOCK, $.01
PAR VALUE PER SHARE (Title of Class)

Check whether the registrant (1) has filed all reports required 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______
                                      -----               


Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B
is not contained in this form, 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-KSB or any amendment to
this Form 10-KSB.    X
                   -----

REGISTRANT'S REVENUES FOR ITS MOST RECENT FISCAL YEAR WERE $9,089,000.

AS OF MARCH 9, 1998, THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-
AFFILIATES COMPUTED BY REFERENCE TO THE PRICE AT WHICH THE STOCK WAS SOLD, OR
THE AVERAGE BID AND ASKED PRICES OF SUCH STOCK, WAS $5,253,930.

AS OF MARCH 9, 1998, THERE WERE 1,920,000 SHARES OF COMMON STOCK OUTSTANDING.

Transitional Small Business Disclosure Format (check one):   YES_____    NO  X
                                                                           -----

DOCUMENTS INCORPORATED BY REFERENCE: REGISTRANT'S PROXY STATEMENT FOR THE 1998
ANNUAL MEETING OF STOCKHOLDERS IS INCORPORATED BY REFERENCE IN PART III, ITEMS 9
THROUGH 12, OF THIS FORM 10-KSB.
<PAGE>
 
                                  FORM 10-KSB

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
ITEM      PART I                                                                               PAGE
<S>                                                                                            <C> 
 1.       Description of Business                                                              1

 2.       Description of Property                                                              10

 3.       Legal Proceedings                                                                    10

 4.       Submission of Matters to a Vote of Security Holders                                  11


          PART II


 5.       Market for Common Equity and Related Stockholder Matters                             11

 6.       Management's Discussion and Analysis or Plan of Operation                            12

 7.       Financial Statements                                                                 17

 8.       Changes In and Disagreements With Accountants on Accounting and Financial            17
          Disclosure


          PART III


 9.       Directors, Executive Officers, Promoters and Control Persons; Compliance With        17
          Section 16(a) of the Exchange Act

10.       Executive Compensation                                                               17

11.       Security Ownership of Certain Beneficial Owners and Management                       17

12.       Certain Relationships and Related Transactions                                       18

13.       Exhibits and Reports on Form 8-K                                                     18

Signatures                                                                                     21

Financial Information
                                                                                       Appendix A
</TABLE>

                                       i
<PAGE>
 
                                    PART I

ITEM 1.  DESCRIPTION OF BUSINESS.

GENERAL

   CD Warehouse, Inc. (together with its wholly owned subsidiary, Compact Discs
Management, Inc., the "Company") is engaged in the franchising and ownership of
music stores offering new and preowned compact discs ("CD's") and related
products under the tradename of "CD Warehouse." Since its initial public
offering in January 1997 (the "Offering"), the Company has engaged in a program
of expansion to achieve strong market recognition in the retail music industry.
This expansion has been accomplished primarily through the sale of new
franchises and the conversion of existing independent retail music stores to
Company-owned stores, as well as the acquisition by the Company of existing
franchised stores. At December 31, 1997, there were 150 franchised and Company-
owned CD Warehouse stores in 29 states, England, France and Venezuela.

   CD Warehouse stores sell their products to the general public in the market
area where the respective store is located. A typical CD Warehouse store,
located in a high traffic strip shopping center, will occupy between 1,200 and
2,500 square feet and offer between 10,000 and 16,000 selections, with
approximately 70% of the dollar sales volume being preowned selections and the
balance being new releases from the major music categories. At each CD Warehouse
store, a customer selects from a number of new and preowned CD's and may listen
to preowned CD's before purchase. CD Warehouse sells CD's, takes customers' CD's
in trade or buys customers' CD's for cash. Typically, each CD Warehouse store
carries the majority of the Billboard Top 100 selections as "new" inventory,
filling out its inventory selection with preowned CD's which are purchased for
$1 to $4 and remarketed for $6 to $9.

   During the year ended December 31, 1997, the Company had total revenues of
approximately $9,089,000, and net income of approximately $386,000. The
Company's expansion strategy for 1998 is to open 30 to 40 franchised stores and
open or acquire 12 to 15 Company-owned stores.

HISTORY

   The Company was formed in September 1996 to acquire the assets of Compact
Discs International, Ltd. ("CDIL"), a Texas limited partnership which franchised
stores throughout the United States and England under the name "CD Warehouse." A
portion of the proceeds of the Company's Offering was used to fund the $3.2
million acquisition (the "CDIL Acquisition"), which was consummated
simultaneously with the closing of the Offering. See Item 12-Certain
Relationships and Related Transactions. In a related transaction (the "MacDonald
Acquisition"), which also occurred simultaneously with the closing of the
Offering, the Company acquired the equity interests of Bruce D. MacDonald
(together with his affiliates, "MacDonald") in various partnerships or other
entities which acted as CD Warehouse franchisees with respect to 36 franchised
CD Warehouse stores. See Item 12-Certain Relationships and Related Transactions.
As a result of the CDIL Acquisition and the MacDonald Acquisition, the Company
acquired the rights to the CD Warehouse name, assumed CDIL's role as franchisor
under the franchise agreements to which CDIL was a party and acquired interests
in the CD Warehouse stores in which MacDonald had an interest.

RECENT EVENTS

   In December 1997, the Company sold its minority equity interests in nine
partnerships to MacDonald. The partnerships, which act as franchisees of the
Company, operate nine CD Warehouse stores. See Item 12-Certain Relationships and
Related Transactions. Pursuant to the sale, MacDonald assumed the Company's
interest in the partnerships, which continue to operate as CD Warehouse
franchisees.

   Effective January 1, 1998, the Company purchased the assets of a franchisee,
ZDTMAC, a general partnership. The aggregate purchase price of $573,530 was paid
$211,030 in cash and $362,500 in restricted Common Stock of the Company, valued
for purposes of the acquisition at $3.625 per share. Pursuant to the
acquisition, the five CD Warehouse stores operated by ZDTMAC will become 
Company-owned stores.

                                       1
<PAGE>
 
   Certain statements contained herein relating to the Company's proposed
business strategy and expansion plans are not based on historical facts, but are
forward-looking statements that are based upon numerous assumptions about future
conditions which may ultimately prove to be inaccurate and actual events and
results may materially differ from anticipated results described in such
statements. The Company's ability to achieve such results is subject to certain
risks and uncertainties, such as those inherent generally in the retail and
franchising industries, the impact of competition and pricing, changing market
conditions, the risks detailed in the sections entitled Item 3-Legal Proceedings
and other risks detailed throughout this Annual Report (the "Report"). These
forward-looking statements represent the Company's judgment as of the filing
date of this Report. The Company disclaims, however, any intent or obligation to
update these forward-looking statements. As a result, the reader is cautioned
not to place reliance on these forward-looking statements. Further, there can be
no assurance that the historical level of the Company's revenues and net income
will continue to be achieved in the future.

BUSINESS STRATEGY

   The Company believes that there is a growing consumer willingness to purchase
preowned CD's, which is providing an expanding market niche in the retail music
industry for CD resellers. The Company's business strategy is to establish
itself as the recognized industry leader in the domestic buy-sell-trade retail
CD marketplace by pursuing a three-fold approach: (1) offering quality, preowned
CD's at exceptional value; (2) offering to accept as a trade, or buy for cash,
selected CD's from customers; and (3) selling new releases at competitive
prices.

   According to the Recording Industry Association of America (the "RIAA"),
annual CD sales in the United States for 1997 exceeded $9.92 billion. The lack
of any audible difference between new and preowned CD's, durability of the
medium, cost savings and the accumulating stock of available CDs for resale,
suggest the possibility for rapid market growth in the preowned CD market.
Because the CD is encased in plastic and read by a laser, the playing of CD's,
and even the occasional careless handling of CDs, rarely cause damage that will
impair performance or result in any degradation of sound quality. In the absence
of pronounced abuse, CD's may reasonably be expected to last for decades;
premium (gold-plated) CD's may last for centuries. Such extraordinary
durability, coupled with the standard error-correction circuitry in CD players,
means that preowned CDs are essentially indistinguishable from new CDs in terms
of audible performance. By offering quality preowned CD's at substantial savings
and responding to consumers' desire to recycle merchandise they no longer want
or use but which has intrinsic value, the CD Warehouse remarketing concept
emphasizes consumer value.

   The Company's expansion strategy for 1998 is to open 30 to 40 franchised
stores and open or acquire 12 to 15 Company-stores. Management believes that, in
addition to the Company, Disc Go Round and The Wherehouse are the only national
chains engaged in the sale of preowned CD's. Based on publicly available
information regarding such companies, the Company believes that CD Warehouse
stores currently account for approximately 29% of the estimated 520 chain-based
CD reseller stores that operate throughout the United States. Management
believes that the market for CD remarketers is fragmented and underserved, and
that the Company can increase its market share by expanding the CD Warehouse
concept in targeted markets. To accomplish this objective, the Company employs a
business strategy that includes the following elements:

   Inventory Management System.  The Company considers its inventory management
system, which is a proprietary software program, to be essential to the success
of its business strategy and the CD Warehouse concept. The program, which has a
database in excess of 70,000 titles and includes catalogs from all the major
record labels, assists each store in selectively procuring preowned CD's by
supplying buying directions for every CD offered. The ability to access this
data instantly gives store operators the capability to make an informed decision
on every CD presented by a customer for purchase or trade, by reviewing the
title's historic sales data, as well as the recommended purchase price that the
CD has been assigned by the Company. By scanning each CD (utilizing bar coding
capability), the program also includes point-of-sale recording of all
transactions, including customer profiles with which mailing lists may be
created. Additionally, as each transaction is entered, the program provides for
the printing of customer receipts which concurrently compiles inventory by
title, including respective costs, selling price and gross profit results.
Accordingly, the program can generate reports of comprehensive data for any
selected period or any facet of store operations, including sales by title,
sales by dollar volume, inventory by title, individual transaction summaries,
acquisitions for any period, system adjustments, cash register reconciliation
and virtually any other pertinent financial information.

                                       2
<PAGE>
 
   The Company believes that its inventory management system contributes to more
efficient system-wide management of inventory by reducing the need to purchase
new titles from music distributors for new store inventories and affording
existing stores the opportunity to sell excess inventory. As new stores are
developed, opening packages of inventory are assembled by the Company and sold
to the franchisees. The demand for inventory by new stores allows existing
stores to sell excess inventory. If, for example, it is determined that a store
may be overstocked on a particular selection, the Company may purchase the
selection and resell it to another unit or as part of the opening inventory of a
new store. The Company believes that this is a significant advantage in
comparison to its competitors since the Company can review all titles available
and source its own system for inventory. Management anticipates as much as 75%
of the opening inventory for a new store can be purchased from the current
system of CD Warehouse stores. This constant inventory turnover allows existing
stores to make a reasonable profit and provide a source of capital while
providing an opportunity for the Company to acquire quality inventory to open
new stores or update an existing location's inventory.

   The Company currently is developing enhancements of its proprietary software
system. These enhancements will include such features as (i) a communication
upgrade that will allow all stores to communicate with the Company and with each
other, and (ii) an accounting package that will produce a profit and loss
statement from the information captured by a store's point-of-sale register.

   Customer Service.  The Company emphasizes excellent customer service and
seeks to employ, and to sell franchises to, motivated and energetic people. The
Company also seeks to foster enthusiasm for its customer service philosophy and
the CD Warehouse concept through annual franchise conventions, regional meetings
and other frequent contacts with its franchisees and store managers.

   Targeted Expansion.  The Company believes that its existing core and
developing markets offer significant growth opportunity for both Company-owned
and franchised store development. The Company intends to concentrate its
expansion of Company-owned stores in markets where it can cluster stores,
thereby expanding consumer awareness and creating significant operating,
distribution and advertising efficiencies. To increase its penetration of core
markets, the Company intends to continue to co-develop markets with franchisees,
divide markets among franchisees or divide markets among the Company and
franchisees. The Company also intends to cluster its Company-owned stores and
franchised stores through the use of area development agreements and its site
selection approval process. The Company believes that this approach will result
in increased average store sales.

STORE LOCATIONS

   The table below illustrates the location of all CD Warehouse retail stores in
the United States, England, France and Venezuela as of December 31, 1997:

DOMESTIC                      FLORIDA                  Sarasota       
--------                      
                              Bradenton                Tallahassee     
ALABAMA                       Coral Gables*            Tampa*          
Decatur                       Davie                    Venice          
Homewood                      Fern Park*                               
Hoover                        Ft. Lauderdale           GEORGIA         
Huntsville                    Ft. Myers                Martinez        
Mobile                        Gainesville                              
                              Jacksonville (2)*        IDAHO           
ARKANSAS                      Lake Park                Idaho Falls      
Fort Smith                    Naples                                    
Little Rock*                  Neptune Beach*           ILLINOIS         
North Little Rock*            North Miami*             Carol Stream     
                              Orange Park*             Lombard          
COLORADO                      Orlando*                 Palatine         
Colorado Springs              Palm Harbor*             Streamwood       
Ft. Collins*                  Port Charlotte           Wheaton           
                                                       

                                       3
<PAGE>
 
IOWA                NEW JERSEY                     Houston (2)                 
Davenport           Belleville                     Houston - D.S. Shepherd*     
Des Moines          Laurel Springs                 Houston  Beechnut*           
Sioux City          Northfield                     Irving*                      
Waterloo                                           Lewisville                   
                    NEW YORK                       Lubbock                      
INDIANA             Rockville Centre               Mesquite                     
Indianapolis        Wantaugh                       Midland*                     
                                                   North Richland Hills         
                    OHIO                           Plano                        
KANSAS              Boardman                       Rockwall                     
Overland Park*      Cleveland Heights              Round Rock                   
Shawnee*            Columbus (2)                   San Angelo                   
                    Holland                        San Antonio (5)              
KENTUCKY            Mayfield Heights               Sherman                      
Paducah             Miamisburg                     Texarkana                    
                    Parma Heights                  Waco*                        
LOUISIANA           Toledo                         Webster*                     
Baton Rouge*                                       Wichita Falls                
Baton Rouge         OKLAHOMA                                                    
Bossier City        Edmond*                        UTAH                         
Kenner              Oklahoma City-North May*       Provo                        
Lafayette*          Oklahoma City-NW Expressway    St. George                   
Metarie*            Tulsa - S Sheridan*            Taylorsville                 
Shreveport          Tulsa - S Peoria                                            
Slidell                                            VIRGINIA                     
                    PENNSYLVANIA                   Alexandria                   
MARYLAND            Pittsburgh                                                  
Laurel                                             WASHINGTON                   
                    SOUTH CAROLINA                 Seattle                      
MISSOURI            Greenville                                                  
Arnold                                             WISCONSIN                    
Ballwin             TENNESSEE                      Appleton                     
Cape Girardeau      Jackson                        Brookfield                   
Gladstone*          Memphis                        Kenosha                      
Independence*                                      Madison                      
Lee Summit*         TEXAS                                                       
Springfield*        Abilene                        INTERNATIONAL                
                                                   -------------                
St. Louis           Arlington - Cooper Street*                                  
                    Arlington - N Collins          ENGLAND                      
MONTANA             Austin (3)                     Ealing                       
Bozeman             Carrollton                     Leeds       
Great Falls         College Station*               London      
                    Dallas - Montfort*             Watford     
NORTH CAROLINA      Dallas (5)                                   
Goldsboro           Denton                         FRANCE        
                    Duncanville                    Caen          
NEBRASKA            El Paso*                                     
Omaha*              Ft. Worth (2)                  VENEZUELA     
                    Garland                        Caracus       
                    Grand Prairie                                

_______________________________

*      Indicates Company-owned stores or stores in which the Company owns an
equity interest.

                                       4
<PAGE>
 
EXPANSION STRATEGY

    The first CD Warehouse store opened in Dallas, Texas in August 1992 and, as
of December 31, 1997, there were a total of 150 CD Warehouse stores in 29
states, England, France and Venezuela. In 1998, the Company expects to open 30
to 40 new franchised stores and open or acquire 12 to 15 new Company-owned
stores. Key elements of the Company's expansion strategy include:

    Aggressive, Balanced Growth. The Company's expansion strategy is to increase
the number of franchised stores by selective utilization of Company-owned stores
in a particular market area. The Company believes that, in many cases, the
Company will be able to take advantage of a promising new location by
establishing a Company-owned store when a delay in finding a qualified
franchisee might jeopardize the Company's ability to secure the site. Company-
owned stores also provide a training ground for Company-owned store and district
managers and a controllable testing ground for new products and promotions,
operating and training methods and merchandising techniques. However, the
cornerstone of the Company's expansion strategy remains the addition of new
franchised stores in the system, which enables the Company to expand its system
more quickly with no capital investment.

    Name Recognition and New Market Penetration.  The Company believes the
visibility of its stores at high traffic, Class A, strip shopping centers has
generated good name recognition in the areas in which stores currently are
located. CD Warehouse stores historically have been concentrated in the
Southwest United States, but recent growth has generated a gradual shift outward
into adjoining states and scattered parts of the Midwestern and Southeastern
United States. The Company's expansion strategy involves initially the building-
out of these existing markets and subsequently the further penetration of
developing markets through the clustering of both Company-owned and franchised
stores. This expansion strategy is designed to take advantage of operational and
advertising efficiencies through store clustering within television and other
advertising markets, thereby increasing market penetration and consumer
awareness. To accelerate penetration of larger markets, the Company intends to
continue to co-develop markets with franchisees or divide markets among
franchisees, and intends to utilize market co-development where appropriate. In
determining which new markets to develop, the Company considers many factors,
including the size of the market, demographics, cost of media, population
trends, competition and real estate availability and pricing.

    International Franchise Expansion.  There are four franchised stores
currently operating in England, one in France and one in Venezuela. The Company
has entered into a master franchise agreement (the "Worldwide Area Development
Agreement") with Mark E. Kane, the founder of CDIL. See Item 12-Certain
Relationships and Related Transactions. The Worldwide Area Development Agreement
provides for a period of ten years for development of franchise operations
worldwide, excluding the United States, Canada and Mexico, and includes a
provision which allows the Company, at its option, to purchase Mr. Kane's
interest in any franchised operations developed pursuant to the Worldwide Area
Development Agreement. The development schedule under the agreement requires
that Mr. Kane open 100 stores over the ten year period. The agreement provides
that Mr. Kane will pay the Company an amount to be jointly determined between
the Company and Mr. Kane on a country-by-country basis, provided that the
Company will receive a franchise fee of not less than $3,000 per store, a
minimum royalty of 1% of gross sales based on individual store sales volume and
20% of the total fee received from each subfranchisee by Mr. Kane. The Company's
intent is to focus its own efforts on developing the CD Warehouse franchise
system domestically, and it considers the Worldwide Area Development Agreement
an attractive vehicle to utilize the expertise of Mr. Kane to develop the
international franchise system. See Item 12 - Certain Relationships and Related
Transactions.

    Consideration of Acquisitions.  Concurrently with the Offering, the Company
acquired the interests of MacDonald, the then largest CD Warehouse franchisee.
The Company intends to pursue the acquisition of other local and regional
preowned music retailers to implement its strategy of building out current
markets and establishing itself in new target markets that may be concurrently
developed by the Company as well as franchised stores.

    New Store Concept.  The Company is investigating the need for a new,
consistent appearance, both externally and internally, for all units. A
prototype unit, which will be a Company-owned store, will open in March 1998 in
Norman, Oklahoma. This store will carry slightly more inventory (18,000 titles)
than is currently carried by existing CD Warehouse stores (10,000 5o 16,000
titles) and will utilize updated decor and lighting schemes. The Company
believes that it can derive greater profits by offering a larger variety in both
new and preowned CD titles. Based on the success of the prototype, a uniform,
low cost remodel plan will be devised for the system as a whole.

                                       5
<PAGE>
 
OPERATIONS

   Acquisition of Preowned CD's.  A key component of the CD Warehouse concept is
to accept as a trade or buy for cash selected CD's from customers; accordingly,
the Company obtains a significant portion of its preowned CD inventory primarily
from within the system itself.  Additionally, utilizing its inventory management
system, which is a proprietary program, the Company affords existing stores the
opportunity to sell excess inventory.  As new stores are developed, opening
packages of inventory are assembled by the Company and sold to the franchisees.
The demand for inventory by new stores allows existing stores to sell excess
inventory.  If, for example, it is determined that a store may be overstocked on
a particular selection, the Company may purchase the selection and resell it as
part of the opening inventory of a new store.  The Company believes that this is
a significant advantage in comparison to its competitors since the Company can
review all titles available and source its own system for inventory.  As much as
75% of the opening inventory for a new store can be purchased from the current
system of CD Warehouse stores.  This constant inventory turnover allows existing
stores to make a reasonable profit and provide a source of capital while
providing an opportunity for the Company to acquire quality inventory to open
new stores or update an existing location's inventory.

   Purchasing of New CD's, Other Point-of-Sale Items and Store Fixtures. For new
music releases, the Company contracts with six major industry CD suppliers (Sony
Music; Warner/Elektra/Atlantic Corp. (subsidiary of Time Warner); BMG Music
(subsidiary of Bertelsman); MCA, Inc. (subsidiary of Matsushita); PolyGram
(subsidiary of Philips); and CEMA (subsidiary of Thorn-EMI) to provide the
necessary access to new titles. As these new releases become available, the
Company reviews all titles and determines what specific releases will be
acquired for sale to the system. The Company then provides a weekly sales
program to franchisees and Company-owned stores consisting of available
inventory. This program includes new releases, catalog titles (i.e., Elvis
Presley, Pink Floyd, movie soundtracks, etc.), preowned titles and various point
of sale and merchandising items. The Company negotiates with venders on behalf
of the system for inventory display racks, lighting and related products which
are then shipped directly from the manufacturers to the individual stores.

   As the system grows, the Company believes that additional quantity discounts
can be negotiated with the respective equipment and product suppliers.  The
Company maintains its own distribution facility to provide its franchise and
Company-owned stores with available new and preowned CD's.

MARKETING AND ADVERTISING

   The Company provides new stores with certain pre-opening items and point-of-
sale materials. Additional point-of-sales materials are available to all stores
at no cost from the record companies. Pursuant to the franchise agreement, which
provides for each store to spend 2.5% of sales specifically on advertising, each
CD Warehouse franchisee currently conducts its own marketing and advertising
activities independently through newspapers and radio. In May 1997, the Company
was instrumental in the formation of an advertising co-op in Dallas, Texas. All
CD Warehouse stores in the Dallas, Texas trade area formed the co-op and agreed
to contribute to the co-op 1.25% of sales on a monthly basis. The co-op meets
monthly to determine how the co-op funds will be utilized to promote the sales
of music in the Dallas market area. During 1998, the Company anticipates the
activation of a system-wide advertising fund (the "SAF"). The SAF will have the
primary purpose of promoting the national awareness of the brand name "CD
Warehouse." The Company expects that the SAF will become the primary creative
and production vehicle for all marketing efforts within the CD Warehouse system.
RANCHISING PROGRAM

   General.  As of December 31, 1997, there were a total of 150 CD Warehouse
stores in 29 states, England, France and Venezuela. The Company expects to open
30 to 40 new franchised stores by the end of 1998. However, there can be no
assurance that all of these stores will be opened or that the development
schedule set forth in each area development agreement will be achieved. Pursuant
to the terms of existing area development agreements, a total of 42 stores are
committed to be opened over the next two years.

   The Company's franchise agreement provides the franchisee the right to use or
be provided, as the case may be, the Company's trade names, service marks and
trademarks; design plans, color schemes, signs and fixtures for store premises;
buying and selling guidelines; computerized inventory management system; initial
inventory, operations and financial control guidelines; initial management
training; and advertising assistance.

                                       6
<PAGE>
 
   The following table sets forth the number of CD Warehouse stores opened and
closed since the inception of the CD Warehouse franchise system:

<TABLE>
<CAPTION>
                        1992   1993     1994    1995    1997    1996    TOTAL
                        ----   ----     ----    ----    ----    ----    
          <S>           <C>    <C>      <C>     <C>     <C>     <C>     <C> 
          Opened         2      17       51      36      24       50     180
                                                                        
          Closed         0       0        3       7       7       13      30
                                                                         ---
                    Open at December 31, 1997                            150 
                                                                         ===  
</TABLE>


   The 1997 activity set forth above includes the opening of ten Company-owned
stores (seven new and three acquired from non-franchisees) of which two were
closed by year end. The above activity does not reflect the conversion of five
franchised stores to Company-owned stores.

   Franchise Sourcing and Selection.  The majority of new franchises are
individuals responding to advertisements in national publications such as
Entrepreneur Magazine and Successful Franchising. Various publications also
publish articles or rankings of top-selling franchises (e.g., in November 1997,
CD Warehouse was listed in "The Franchise Gold 100" by Success magazine), which
also elicit inquiries from potential franchisees. Franchisees are approved by
the Company on the basis of the applicant's net worth and liquidity, together
with an assessment of work ethic and personality compatibility with the
Company's operating philosophy.

   Franchise Marketing Program.  The Company's franchise marketing program seeks
to attract prospective franchisees with management experience, a minimum level
of net worth and strong interest in the retail music business. The Company
markets its franchise opportunities by advertising in selected business
magazines and franchise-oriented publications. Each inquiry is responded to and
an initial determination is made as to the prospect's qualifications to become a
CD Warehouse franchisee. Once an inquiry is received, the prospect is mailed the
Company's brochure and marketing materials. The inquiry is then followed up on
within a period of two weeks.
 
   The Company has established a home page via the Internet (World Wide Web)
that will provide detail on the franchise opportunities presented by operating a
CD Warehouse store. The Company's homepage can be accessed at
http://www.cdwarehouse.com/.

   Training and Support.  The Company's philosophy is one of service and
commitment to its system. Each franchise owner/operator and each company store
manager is required to complete a comprehensive training program in store
operation and management. Topics covered in the training course include the
Company's philosophy of store operation and management, customer service,
merchandising, marketing, pricing, inventory and cost control, record keeping,
labor scheduling and personnel management. Training is based on standard
operating policies and procedures contained in an operations manual provided to
all franchisees, which the franchisee is required to follow by terms of the
franchise agreement. Additionally, trainees are provided with a complete
orientation to Company operations by meeting with members of the senior
management of the Company. Training continues through the opening of the store,
where Company field personnel assist and guide the franchisee in all areas of
operation.

   The Franchise Agreement; Terms and Conditions.  The domestic offer and sale
of CD Warehouse franchises is made by its Uniform Franchise Offering Circular
prepared in accordance with federal and state laws and regulations. States that
regulate the sale and operation of franchises require a franchisor to register
or file certain notices with the state authorities prior to offering and selling
franchises in those states.

   Under the current form of domestic franchise agreement, which became
effective March 26, 1997, franchisees generally pay the Company (i) an initial
franchise fee of $15,000, (ii) royalties equal to 5% of monthly gross sales and
(iii) a marketing fee equal to 2.5% of monthly gross sales. CD Warehouse
franchisees existing prior to January 27, 1997 (the date of the CDIL
Acquisition), who enter into a franchise agreement for a new location on or
prior to December 31, 1998, will pay the Company (i) an initial franchise fee of
$6,000; (ii) royalties equal to 5% of monthly gross sales and (iii) a marketing
fee equal to 2.5% of monthly gross sales. Franchisees are generally granted
exclusive territory with respect to the operation of CD Warehouse stores only in
the immediate vicinity of their stores.

                                       7
<PAGE>
 
   The franchise agreement requires franchisees to purchase from the Company
certain proprietary software and the store's initial inventory, and to comply
with the Company's procedures of operation, to permit inspections and audits by
the Company and to remodel stores to conform with standards in effect from time
to time for the CD Warehouse system. The Company may terminate the franchise
agreement upon the failure of the franchisee to comply with the conditions of
the agreement and upon the occurrence of certain events, such as insolvency or
bankruptcy of the franchisee or the commission by the franchisee of any unlawful
or deceptive practice which in the judgment of the Company is likely to
adversely affect the CD Warehouse system. The Company's ability to terminate
franchise agreements pursuant to such provisions is subject to applicable
bankruptcy and state laws and regulations.

   The franchise agreement prohibits the transfer or assignment of any interest
in a franchise without the prior written consent of the Company. The franchise
agreement also gives the Company a right of first refusal to purchase any
interest in a franchise if a proposed transfer would result in a change of
control of that franchise. The refusal right, if exercised, would allow the
Company to purchase the interest proposed to be transferred under the same terms
and conditions and for the same price as offered by the proposed transferee.

   The term of each franchise agreement is ten years, and franchisees generally
have the right to renew for an additional ten-year term. All of the franchise
agreements assigned to the Company in connection with the CDIL Acquisition will
expire between 2002 and 2006.

   UNIT ECONOMICS.  The Company believes that future CD Warehouse stores can be
opened for an initial investment of $88,000 to $113,000. The estimated initial
investment is comprised of the following:

<TABLE>
<CAPTION>
                                                             MINIMUM   MAXIMUM
                                                             -------   -------
<S>                                                         <C>       <C>    
          Franchise Fee............................         $  6,000  $ 15,000
          Inventory................................           45,000    55,000
          Leasehold Improvements...................            9,500    11,500
          Proprietary Software.....................            1,500     1,500
          Signage (exterior and interior)..........            5,500     7,000
          Fixtures and equipment...................            9,000    10,000
          Lease and utility deposits...............            1,500     3,000
          Initial working capital..................           10,000    10,000
                                                              ------    ------
                 Total.............................         $ 88,000  $113,000
                                                              ======   =======
</TABLE>


   Management believes that a key indicator of the success of a franchise
location is the sales to capitalization ratio. That ratio is defined as the
annual sales revenue generated by the business divided by the capitalization
costs to open the business. For the year ended December 31, 1997, average unit
sales on a comparable basis were $306,000. Based on an average initial estimated
capitalization of $100,000, the sales to capitalization ratio to open a new CD
Warehouse store is 3.06 to 1.

   Franchise Financing.  Typically, franchisees obtain their own sources of
financing and do not require the Company's assistance. However, the Company in
March 1997 executed an agreement with Berthel Fisher Leasing Company, Inc.
("Berthel Fisher"), pursuant to which Berthel Fisher agreed to provide up to an
aggregate $1 million of equipment, furniture and fixtures financing to new
franchisees. Although the Company paid $20,000 to Berthel Fisher as a commitment
fee to have the credit available, it is not a guarantor or otherwise a party to
any financing arrangement between a franchisee and Berthel Fisher.

COMPANY STORE PROGRAM

   Prior to 1997 the Company was not involved in the operation of retail stores.
Pursuant to the MacDonald Acquisition, the Company began operating and/or
managing retail stores. During 1997, the Company opened and/or acquired 13
stores. During 1998, the Company intends to open or acquire 12 to 15 new stores.

                                       8
<PAGE>
 
   Company-owned stores permit market penetration, or seeding, in the absence of
an immediately viable multi-location franchise operator.  Company stores provide
an opportunity to continually refine the Company's standard store model in order
to respond to market dynamics.  Variations in inventory mix, ancillary product
offerings, and marketing and sales techniques can be tested and refined before
implementation throughout the system.

   Managers of Company-owned stores are required to comply with all Company
operating standards and undergo training and receive support from the Company
similar to the training and support provided to franchisees.  See Item
1--Description of Business.  The Company's Director of Company Store Operations
and his staff regularly visit Company-owned stores to ensure compliance with
Company standards and procedures and to provide advice and support.

GOVERNMENTAL REGULATION

   The Company is subject to various federal, state and local laws affecting its
business.  Each of the Company's stores is subject to licensing and regulation
by a number of governmental authorities, which include taxing, zoning and
building agencies in the state or municipality in which the store is located.
Difficulties in obtaining or failures to obtain required licenses or approvals
could delay or prevent the opening a new store in a particular area.

   The Company is subject to Federal Trade Commission ("FTC") regulation and
various state laws that regulate the offer and sale of franchises.  The FTC has
adopted a rule that requires franchisors to make certain disclosures to
prospective franchise owners prior to the offer or sale of franchises.  This
rule requires the disclosure of information necessary for a franchise owner to
make an informed decision as to whether to enter into a franchise relationship
and delineates the circumstances in which franchisors may make predictions on
future sales, income and profits.  Failure to comply with this rule constitutes
an unfair or deceptive act or practice under the Federal Trade Commission Act.
Additionally, numerous states have in recent years adopted laws regulating
franchise operations and the franchisor-franchisee relationship, and similar
legislation is pending in Congress and several other states.  Existing laws and
pending proposals vary from filing and disclosure requirements in the offer and
sale of franchises to the application of statutory standards regulating the
establishment and termination of franchise relationships.  These laws generally
apply to both area and individual franchises. Although the foregoing matters may
result in some modification in the Company's franchising activities and some
delays or failures in enforcing certain of its rights and remedies under certain
area or individual franchise agreements, such modifications, delays or failures
have not had a material adverse effect on the Company's operations or business.
However, the law applicable to franchise operations and relationships is still
developing, and the Company is unable to predict the effect, if any, on its
operations of additional requirements or restrictions that may be enacted or
promulgated or of court decisions that may be adverse to the franchise industry.
While it is difficult to assess potential effects of federal and state
legislation in the U.S. or new international laws that may impact the industry,
the Company does not anticipate any material adverse effects from such
legislation or laws at this time.

   The Company's operations are also subject to federal and state laws governing
such matters as wages, working conditions and overtime.

COMPETITION

   The Company competes in the retail music industry, which is highly
competitive in price, selection, service and location and is often affected by
changes in consumer trends, economic conditions, demographics, traffic patterns
and technological innovations.  The following profile provides an overview and
comparison of how the retail "new release" CD industry and the emerging retail
"remarketing" or "buy-sell-trade" CD industry are currently structured and
segmented.

   According to the RIAA, CD sales in the United States were over $9.92 billion
in 1997.  The Company has various competitors in the industry which sell new
recordings and music related merchandise.  These companies vary from those who
are specialty music stores in malls (such as Musicland and Camelot) and those
who utilize free-standing buildings (such as Blockbuster Music and Wherehouse
Records).  Empirical studies conducted by the Company indicate that companies in
mall locations typically charge $15.99 to $17.99 for their front-line CD
products.  Those in free-standing buildings generally have much larger
facilities (between 12,000 to 20,000 square feet).  Their selling price for
front-line items range between $13.99 and $15.99, with the latest top 20
releases on sale for $11.99 to $13.99 per CD.  None of these "superstores" sell
preowned music except for Wherehouse Records, which has generally offered an
inventory of preowned CDs in less than 500 square feet of space with limited
selections.

                                       9
<PAGE>
 
   Other retailers offering music include major national discount stores,
including Wal-Mart, K-Mart and Target stores. These national discounters
maintain a very small number of new music titles while offering no preowned
music.  Their pricing will typically vary from $11.99 to $13.99 per item in
approximately 1,000 square feet of space.  In another category are the multi-
media electronic stores (such as Best Buy and Circuit City), which have
generally utilized approximately 1,000 square feet of space and discount their
new releases from $9.99 to $12.99 per item.

   The CD Warehouse system competes currently with one other national company
specializing in the sale of preowned CD's.  Disc-Go-Round(R) is a Minneapolis-
based company owned by Grow Biz International, Inc., a franchisor of several
other concepts including Play It Again Sports.  Disc-Go-Round(R) maintains
smaller quantities of preowned inventory than does CD Warehouse.  Both CD
Warehouse and Disc-Go-Round(R) sell preowned CD's at $6.00 to $9.00 and new
releases at $10.99 to $12.99, as compared to Best Buy and Circuit City prices of
new CD's which range generally from $9.99 to $12.99 per selection.  Grow Biz
International, Inc.'s year-end earnings release dated February 27, 1998
indicates that, at December 27, 1997, there were 135 units in the Disc-Go-
Round(R) system, as compared to 150 units in the CD Warehouse system.

   The Company believes that CD Warehouse stores compete favorably with its
competition in the preowned CD market in terms of price, selection, service and
location.

   The Company also competes in the franchise industry for prospective
franchisees.  With respect to the only franchisor known to the Company to engage
in a business similar to that of the Company, the Company believes that it
competes favorably.

TRADEMARKS AND SERVICE MARKS

   The Company has registered the name "CD Warehouse" with the United States
Patent and Trademark Office.  In 1997 the Company also registered its service
mark and copyright for, respectively, its proprietary software system and the
phrase, "The Future of Music."  The Company believes that its trademark, service
mark and copyright have significant value and are important to its marketing
efforts.

EMPLOYEES

   The Company as of March 12, 1998 employs 40 full-time and 40 part-time
employees.  None of the Company's employees are represented by a labor union and
the Company believes that its relations with its employees are good.

ITEM 2.  DESCRIPTION OF PROPERTY.

   The Company's principal executive offices are located at 1204 Sovereign Row,
Oklahoma City, OK 73108.  The total facility is approximately 11,000 square feet
and is held under a 60 month lease with a monthly lease payment of $6,420.  The
expiration date of the lease is August 31, 2002.  Approximately 6,500 square
feet is used for administrative purposes and the balance of the space is
utilized as a warehouse.

ITEM 3.  LEGAL PROCEEDINGS.

   From time to time, the Company may be involved in litigation relating to
claims arising out of its normal business operation.  The Company believes that
such litigation should not have a material adverse effect on the Company's
financial position.

   In September 1997, the Company brought an action in the District Court of
Dallas County, Texas against Grow Biz International, Inc. ("GBI") and Clarence
Gladden ("Gladden"), believed by the Company to be the head of GBI's franchise
sales operations.  GBI's subsidiary, Disc Go Round(R), is a competitor of the
Company.  The Company alleges that Gladden, acting on behalf of GBI, acquired
proprietary information of the Company under the pretext that he wished to
become a franchisee of the Company. The Company alleges fraud, misappropriation
of trade secrets and unfair competition, and seeks monetary damages sufficient
to compensate the Company for its injuries and punitive damages.

                                       10
<PAGE>
 
ITEM 4.  SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS.

   No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.

                                    PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

   The Company's Common Stock began trading on the NASDAQ Small Cap Market
System on January 22, 1997, under the symbol "CDWI".  The following table sets
forth, for the periods indicated, the high and low sale price per share for the
Company's Common Stock:

<TABLE>
<CAPTION>
                         Year Ended December 31, 1997
                         ----------------------------
                             High            Low
                         -------------  -------------
       <S>               <C>            <C>
       First Quarter            $5 1/2         $3 5/8
       Second Quarter           $4 1/2         $2 1/2
       Third Quarter            $4 3/8         $2 3/4
       Fourth Quarter           $    5         $3 5/8
</TABLE>

   At March 9, 1998, there were approximately 53 registered holders of record of
the Common Stock.
 
   The Company has not paid cash dividends on its Common Stock since its
inception and intends to retain earnings for the continued expansion of its
business.

RECENT SALES OF UNREGISTERED SECURITIES

   The following sets forth certain information regarding sales of securities of
the Company issued within the past three years which were not registered
pursuant to the Securities Act of 1933, as amended (the "Securities Act").

   The Company was organized as a Delaware corporation in September 1996.  The
initial subscribing stockholders, who each subscribed on September 5, 1996, were
Jerry W. Grizzle, for 230,000 shares of Common Stock; Matthew Grizzle (Mr.
Grizzle's son), under the Uniform Transfers to Minors Act ("UTMA"), for 10,000
shares of Common Stock; Brittany Grizzle (Mr. Grizzle's daughter), under the
UTMA, for 10,000 shares of Common Stock; Gary D. Johnson, for 75,000 shares of
Common Stock; and Doyle E. Motley, for 25,000 shares of Common Stock.  Each of
such stockholders paid a purchase price of $1.00 per share for the Common Stock
thus purchased.

   The Company entered into a subscription agreement on October 1, 1996 with
Mark E. Kane for the sale to him of 350,000 shares of Common Stock, at a
purchase price of $1.00 per share.  Because payment of the subscription price
was conditioned upon the successful completion of the Offering, the 350,000
shares of Common Stock were issued, and the subscription price was paid, on
January 27, 1997, the closing date of the Offering.  Additionally, in connection
with the closing of the MacDonald Acquisition, on January 27, 1997, Bruce D.
MacDonald was issued an aggregate of 80,000 shares of Common Stock, valued for
purposes of the transaction at $5.00 per share (which was equal to the initial
public offering price of the Common Stock in the Offering).

   Effective January 1, 1998, the Company purchased the assets of a franchisee,
ZDTMAC, a general partnership.  A portion of the purchase price was paid by the
issuance to the general partners of ZDTMAC (or to the equity owners of such
general partners) of 100,000 shares of restricted Common Stock of the Company,
valued for purposes of the acquisition at $3.625 per share.

   No sales commissions were paid in connection with the stock issuances.  The
securities were issued in reliance on the exemption from registration provided
by Section 4(2) of the Securities Act.

                                       11
<PAGE>
 
ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.

STATEMENTS OF OPERATIONS

   The following table sets forth the Company's results of operations for the
year ended December 31, 1997, and the combined unaudited pro forma historical
results of operations for the year ended December 31, 1996, of the CDIL
Acquisition and the MacDonald Acquisition consummated by the Company on January
27, 1997.  The historical information has been adjusted to eliminate operations
retained by CDIL and to provide charges for executive compensation, amortization
of goodwill relating to the above acquisitions and income taxes as explained
below.  The information should be read in conjunction with the historical
Financial Statements included elsewhere in this document.

<TABLE>
<CAPTION>
                                                                    YEARS ENDED DECEMBER 31,         
                                                                   -------------------------         
                                                                       1997          1996            
                                                                   ------------  ------------          
                                                                                 (Predecessor)      
                                                                                 Pro Forma)(1)     
                                                                 (in thousands except share data) 
<S>                                                               <C>           <C>  
Revenues:                                               
                                                                              
     Retail store sales.................................          $    3,352     $      241  
     Wholesale merchandise sales........................               3,903          3,469
     Software income, net...............................                  61              7                                
     Royalty income.....................................               1,394          1,201  
     Management fees....................................                 116              -                                 
     Franchise and development fees.....................                 263             88                                 
                                                                   ---------     ----------             
        Total revenues..................................               9,089          5,006     
                                                                                                          
Operating costs and expenses:
                                                                             
     Cost of sales  retail store sales..................               1,999            150   
     Cost of sales  wholesale merchandise sales.........               3,608          3,277   
     Retail store operating expenses....................               1,226             69   
     General and administrative (2).....................               1,510          1,095(2)    
     Depreciation and amortization......................                 239            193(2)  
     Minority interest in partnership income............                  40              - 
                                                                   ---------     ----------              
        Total operating costs and expenses..............               8,622          4,784 
                                                                   ---------     ----------
Operating income........................................                 467            222 
Other income, net.......................................                 149             48  
Income before provision for  income taxes..............                  616            270(2) 
Provision for income taxes.............................                  230             94(2)  
                                                                   ---------      ---------             
Net income.............................................           $      386     $      176(2) 
                                                                   =========      =========  
Net income per share of common stock...................           $      .23     $      .10
                                                                   =========      ========= 
Shares used in computation.............................            1,714,790      1,820,000
                                                                   =========      ========= 
</TABLE> 

_______________________

Pro forma adjustments to December 31, 1996 historical amounts:

(1)  Operations retained by CDIL have been eliminated from the combined
     information presented above.

(2)  General and administrative expense presented above includes charges for
     executive compensation of $280,000, based on executive compensation paid
     during the year ended December 31, 1997.

     The information presented above has been prepared assuming the Offering and
     resulting acquisition of the assets comprising the CDIL Acquisition and the
     assets comprising the MacDonald Acquisition were completed on January 1,
     1996, resulting in additional amortization of goodwill of $180,000 for the
     year ended December 31, 1996.

                                       12
<PAGE>
 
     The provision for income taxes is based on a rate of 34% applied to pro
     forma income before income tax.

OVERVIEW

  The Company was formed in September 1996 to acquire the franchise operations
of CDIL, a Texas limited partnership which franchised and operated stores
throughout the United States and England under the name "CD Warehouse."  The
first CD Warehouse store was opened in 1992.  At December 31, 1997, there were
144 domestic units operating in 29 states and 6 international units operating in
England, France and Venezuela.

  Simultaneously with the closing of the Offering on January 27, 1997, the
Company acquired the CDIL Assets, consisting primarily of CDIL's rights as
franchisor in the various franchise agreements to which it was a party, for a
purchase price of $3.2 million.  In a related transaction (the "MacDonald
Acquisition"), which also occurred simultaneously with the closing of the
Offering, the Company acquired the equity interest of MacDonald, the then
largest CD Warehouse franchisee, in 36 franchised CD Warehouse stores.  Pursuant
to the MacDonald Acquisition, the Company acquired 100% ownership of one store
and minority equity interests (including MacDonald's interest as a managing
general partner or limited liability company manager) in the other 35 franchised
stores in which MacDonald had an interest.  Effective December 30, 1997, the
Company sold back to MacDonald the Company's various ownership interests in nine
partnerships, for an aggregate consideration of $169,807.  The partnerships,
which act as franchisees of the Company, operate nine CD Warehouse stores.
Pursuant to the sale, MacDonald assumed the Company's interest in the
partnerships, which will continue as CD Warehouse franchisees

  The following discussion and analysis reviews the combined operating results,
as adjusted below, of the CDIL Acquisition and the MacDonald Acquisition
(collectively, the "Predecessor") for the year ended December 31, 1996, and the
activity relating to the operations of the Company for the year ended December
31, 1997, which includes activity relating to the operations of the CDIL Assets
and the MacDonald Acquisition for the period subsequent to January 27, 1997.
Certain statements contained in this discussion are not based on historical
facts, but are forward-looking statements that are based upon numerous
assumptions about future conditions which may ultimately prove to be inaccurate
and actual events and results may materially differ from anticipated results
described in such statements.

              [The balance of this page intentionally left blank]

                                       13
<PAGE>
 
RESULTS OF OPERATIONS

     The following table sets forth the percentage relationship of certain
operating statement data to total revenues, except as otherwise indicated:

<TABLE>
<CAPTION>
                                                       Years Ended December 31,
                                                     ------------  -------------
                                                         1997          1996
                                                     ------------  -------------
<S>                                                  <C>           <C>  
REVENUES:
     Retail store sales............................      36.9%          4.8%
     Wholesale merchandise sales...................      42.9%         69.3%
     Software income, net..........................        .7%           .2% 
     Royalty income................................      15.3%         24.0%
     Management fees...............................       1.3%            -
     Franchise and development fees................       2.9%          1.7%
                                                     --------      --------     
       Total revenues..............................     100.0%        100.0%
                                                          
COST AND EXPENSES:
     Cost of sales  retail store sales (1).........      59.6%         62.2% 
     Cost of sales  wholesale  merchandise
       Sales(2)....................................      92.5%         94.5%
     Retail store operating expenses (1)...........      36.6%         28.6%
     General and administrative                          16.6%         21.9% 
     Depreciation and amortization                        2.6%          3.9%  
     Minority interest in partnership income               .4%            - 
                                                                            
OPERATING INCOME...................................       5.1%          4.4%
                                                                            
NET INCOME.........................................       4.2%          3.5% 
</TABLE>

_______________________

(1)  As a percentage of sales from retail store sales.
(2)  As a percentage of wholesale merchandise sales.

YEAR ENDED DECEMBER 31, 1997 COMPARED WITH THE YEAR ENDED DECEMBER 31, 1996

  As discussed above, the Company acquired the operations of the Predecessor on
January 27, 1997.  Therefore, the results of operations for the year ended
December 31, 1997 only include activity relating to the operations acquired from
the Predecessor from January 27 through December 31, 1997, compared to January 1
through December 31, 1996.

  Revenues

  Retail store sales increased $3,111,000 to $3,352,000 for the year ended
December 31, 1997, compared to $241,000 for the year ended December 31, 1996.
The increase in retail store sales was the result of having thirteen Company-
owned and three majority-owned stores in operation during the year ended
December 31, 1997, compared to only one Company-owned store during the same
period in 1996.

  Wholesale merchandise sales increased $434,000, or 13%, to $3,903,000 for the
year ended December 31, 1997, compared to $3,469,000 for the same period in
1996.  The increase was due to the larger number of operating stores in the
system, which increased from 113 stores at December 31, 1996 to 150 stores at
December 31, 1997 (134 franchise stores, 13 Company-owned stores and 3 majority-
owned stores).  Wholesale merchandise sales for the year ended December 31, 1997
also included approximately $200,000 of "new catalog" product, which was
introduced into the system in March 1997.  Wholesale merchandise sales for the
year ended December 31, 1997 also included the sales of the opening inventory of
up to 50 new stores compared to the only 24 new stores opened during the year in
1996.  

                                       14
<PAGE>
 
Wholesale merchandise sales to Company-owned stores and majority-owned stores of
$1,020,000 for the year ended December 31, 1997 have been eliminated in the
consolidated financial statement presented herein.

   Royalty income increased $193,000 to $1,394,000 for the year ended December
31, 1997, compared to $1,201,000 for the same period in 1996.  Again, the
increase was due to the increased number of operating franchised stores, which
numbered 134 at December 31, 1997, compared to 113 at December 31, 1996.  In
addition, same store sales for the year ended December 31, 1997 increased 14%
while monthly average store sales increased from $21,949 for the year ended
December 31, 1996 to $25,467 for the same period in 1997.  System wide sales for
the year ended December 31, 1997 were $36,495,000, compared to $27,282,000 for
the previous year.  Retail store sales of Company-owned stores and majority-
owned stores included in the above system wide sales were $3,352,000 and
$241,000, respectively.

   Management fees relate to the Company's management of certain franchised
stores in which the Company acquired a minority interest as a result of the
MacDonald Acquisition discussed herein.  No management fees were recognized for
the year ended December 31, 1996.

   Franchise and development fees increased $175,000 to $263,000 for the year
ended December 31, 1997, compared to $88,000 for the same period in 1996.  The
increase was due to the increased number of franchised stores opened during 1997
(40) as compared to 1996 (24), as well as an increase in franchise fees, which
increased from $6,000 to $15,000 for new franchisees.

   Costs and Expenses

   Cost of sales for retail store sales increased $1,849,000 for the year ended
December 31, 1997, compared to the same period in 1996.  This increase is
consistent with the increase of retail store revenue discussed above.  Cost of
sales was 60% of sales for the year ended December 31, 1997, compared to 62% for
the year ended December 31, 1996.  The 2% reduction in cost of sales was due to
improved purchasing of both new and used merchandise and the cost savings
associated with operating multiple stores in 1997 compared to only one store in
1996.

   Costs of sales for wholesale merchandise increased $331,000, or 10%, to
$3,608,000 for the year ended December 31, 1997, compared to $3,277,000 in 1996.
The increase is consistent with the increase in sales.  Cost of sales was 92% of
sales for the year ended December 31, 1997, compared to 94% in 1996.  The
reduction in Cost of Sales was due to improved purchasing power and better
profit margins on "new catalog" products introduced into the system in March
1997.

   Retail store operating expenses increased $1,157,000 to $1,226,000 for the
year ended December 31, 1997, compared to $69,000 for the year ended December
31, 1996.  The increase is due to the increase of Company-owned and majority-
owned stores discussed above.  Retail store operating expense was 29% of retail
store revenue for the year ended December 31, 1996, compared to 37% of retail
store revenue for the same period in 1997.  This increase was due primarily to
start up costs of the twelve new Company stores, which were expensed during the
year ended December 31, 1997, compared to the one established store opened
during the comparable period in 1996.

   General and administrative expenses increased by $415,000 to $1,510,000 for
the year ended December 31, 1997, compared to $1,095,000 (on a pro forma basis)
for the year ended December 31, 1996.  This increase resulted from increased
costs associated with the transition after the acquisitions and Offering
discussed above, relocation of the Company to Oklahoma City, Oklahoma,
additional costs of operating the new facility (which is 175% larger than the
facility previously occupied in Dallas, Texas) and expenses relating to the
management of certain franchised stores discussed above.

   Depreciation and Amortization

   Depreciation and amortization increased $46,000 to $239,000 for the year
ended December 31, 1997, compared to $193,000 (on a pro forma basis) for the
comparable period in 1996. This was primarily due to the addition of twelve
Company-owned stores and three majority-owned stores in 1997.

                                       15
<PAGE>
 
   Net Income

   Net income increased $210,000, or 119%, to $386,000 for the year ended
December 31, 1997, compared to $176,000 (on a pro forma basis) for the same
period ended December 31, 1996.  The increase in net income was due to the
increase in the number of operating stores discussed above, cost savings
associated with increased purchasing power and the increase in franchise and
development fees for the year ended December 31, 1997.

LIQUIDITY AND CAPITAL RESOURCES

   At December 31, 1997, the Company had working capital of $1,931,000 and cash
and cash equivalents aggregating $1,122,000, compared to a negative working
capital of $95,000 and cash and cash equivalents of $15,000 at December 31,
1996.  Net cash used for operating activities was $129,000 for the year ended
December 31, 1997, compared to net cash provided by operating activities of the
Predecessor of $765,000 for the year ended December 31, 1996.  The increased use
of cash by operating activities relates to (i) the opening of twelve new Company
stores (five new, four acquired from franchisees, and three acquired from non-
franchisees), (ii) increasing merchandise inventory and (iii) the overall
increase in system growth.

   Net cash used for investing activities for the year ended December 31, 1997,
was $3,482,000, compared to net cash provided by investing activities of $61,000
by the predecessor for the same period in 1996.  The significant use of cash for
investing activities in 1997 related to the CDIL Acquisition on January 27, 1997
and the opening of Company-owned stores.

   Net cash provided from financing activities was $4,718,000 for the year ended
December 31, 1997, compared to net cash used for financing activities of
$509,000 for the year ended December 31, 1996.  The net cash provided from
financing activities in 1997 related to the Offering and the collection of a
stock subscription in the amount of $350,000. The net cash used in financing
activities by the predecessor for the year ended December 31, 1996 related to
distributions of $509,000 to partners of CDIL.

   In February 1998, the Company finalized a $500,000 Line of Credit and
$500,000 Term Loan Agreement with Merrill Lynch Business Financial Services,
Inc. Amounts borrowed under either the Line of Credit or Term Loan will bear an
interest rate equal to the sum of 3.1% and the thirty-day Commercial Paper Rate.
As of the date of this Report, no funds have been borrowed under either
facility. It is the Company's opinion that the current working capital at
December 31, 1997, combined with amounts available under the two credit
agreements, will be sufficient to support the ongoing activities of the Company
(including the capital needed to open Company stores in 1997) for the
foreseeable future.

OTHER MATTERS

   The Company is currently working to resolve the potential impact of the year
2000 on the processing of date-sensitive information by the Company's
computerized information systems.  The year 2000 problem is the result of
computer programs being written using two digits (rather than four) to define
the applicable year.  Any of the Company's programs that have time-sensitive
software may recognize a date using "00" as the year 1900 rather than the year
2000, which could result in miscalculations or system failures.  Based on
preliminary information, costs of addressing potential problems are not
currently expected to have a material adverse impact on the Company's financial
position, results of operations or cash flows in future periods.  However, if
the Company, its franchisees or vendors are unable to resolve such processing
issues in a timely manner, it could result in a material financial risk.
Accordingly, the Company plans to devote the necessary resources to resolve all
significant year 2000 issues in a timely manner.

                                       16
<PAGE>
 
ITEM 7.  FINANCIAL STATEMENTS.

     The consolidated financial statements of the Company and its predecessor,
CDIL, are incorporated by reference from pages F-1 through F-50 of the attached
Appendix, and include the following:

1.   Historical Financial Statements:

     (a)  Financial Statements of CD Warehouse, Inc.

               (1)  Report of Independent Auditors
               (2)  Consolidated Balance Sheet at December 31, 1997
               (3)  Consolidated Statements of Operations for the year ended
                    December 31, 1997 and for the period from September 5, 1996
                    (inception) to December 31, 1996
               (4)  Consolidated Statements of Stockholders' Equity for the year
                    ended December 31, 1997 and for the period from September 5,
                    1996 (inception) to December 31, 1996
               (5)  Consolidated Statement of Cash Flows for the year ended
                    December 31, 1997 and for the period from September 5, 1996
                    (inception) to December 31, 1996
               (6)  Notes to Consolidated Financial Statements

     (b)  Financial Statements of Compact Discs International, Ltd.

               (1)  Independent Auditors' Report
               (2)  Balance Sheet at December 31, 1996
               (3)  Statement of Income for the year ended December 31, 1996
               (4)  Statement of Partners' Capital for the year ended December
                    31, 1996
               (5)  Statement of Cash Flows for the year ended December 31, 1996
               (6)  Notes to Financial Statements

2.  Pro Forma Combined Condensed Statement of Operations for the year ended
December 31, 1996

ITEM 8.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE

     There have been no material disagreements between the Company and its
independent accountants on accounting and financial disclosure matters which are
required to be reported under this Item for the period for which this Report is
filed.

                                   PART III

ITEM 9.   DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
          COMPLIANCE WITH 16(A) OF THE EXCHANGE ACT

     The information required will be contained in the Company's Proxy Statement
for the 1998 Annual Meeting of Stockholders and is incorporated herein by
reference.

ITEM 10.  EXECUTIVE COMPENSATION.

     The information required will be contained in the Company's Proxy Statement
for the 1998 Annual Meeting of Stockholders and is incorporated herein by
reference.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

     The information required will be contained in the Company's Proxy Statement
for the 1998 Annual Meeting of Stockholders and is incorporated herein by
reference.

                                       17
<PAGE>
 
ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The information required will be contained in the Company's Proxy Statement
for the 1998 Annual Meeting of Stockholders and is incorporated herein by
reference.

ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K.

(a)  The following documents are filed as part of this report:

     (1)  Financial Statements are attached hereto as Appendix A and included
          herein on pages F-1 through F-50.

     (2)  The following Exhibits are filed with this Report or are incorporated
          by reference as set forth below:

 Exhibit
 Number                                Name of Exhibit 
 ------                                ---------------               
     
     2.1  Asset Purchase Agreement, dated as of October 1, 1996, by and among
          Compact Discs International, Ltd., Mark E. Kane ("Kane") and the
          Company (filed as Exhibit 2.1 to the Company's Registration Statement
          on Form SB-2, file number 333-15139 and incorporated herein by
          reference)

     2.2  Asset Purchase Agreement, dated as of October 10, 1996, by and between
          Bruce D. MacDonald ("MacDonald") and the Company (filed as Exhibit 2.2
          to the Company's Registration Statement on Form SB-2, file number 333-
          15139 and incorporated herein by reference)
        
     2.3  Assignment and Assumption Agreement, dated as of October 10, 1996, by
          and between MacDonald and the Company (filed as Exhibit 2.3 to the
          Company's Registration Statement on Form SB-2, file number 333-15139
          and incorporated herein by reference)
        
     3.1  Amended and Restated Certificate of Incorporation (filed as Exhibit
          3.1 to the Company's Registration Statement on Form SB-2, file number
          333-15139 and incorporated herein by reference)
        
     3.2  Amended and Restated Bylaws (filed as Exhibit 3.2 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)

     4.1  Specimen Certificate of the Common Stock (filed as Exhibit 4.1 to the
          Company's Registration Statement on Form SB-2, file number 333-15139
          and incorporated herein by reference)
 
     4.2  See Articles IV and VIII of the Company's Certificate of Incorporation
          and Article II of the Company's Bylaws (filed as Exhibit 4.2 to the
          Company's Registration Statement on Form SB-2, file number 333-15139
          and incorporated herein by reference)

     4.3  Form of Warrant Agreement between the Company and the Underwriters
          (filed as Exhibit 4.3 to the Company's Registration Statement on Form
          SB-2, file number 333-15139 and incorporated herein by reference)
 
     4.4  WCMA(R) Note, Loan and Security Agreement dated as of December 4,
          1997, between the Company and Merrill Lynch Business Financial
          Services Inc. (filed as Exhibit 10.1 to the Company's Form 8-K dated
          February 10, 1998 and incorporated herein by reference)
 
     4.5  Term WCMA(R) Loan and Security Agreement dated as of November 28,
          1997, between the Company and Merrill Lynch Business Financial
          Services Inc. (filed as Exhibit 10.2 to the Company's Form 8-K dated
          February 10, 1998 and incorporated herein by reference)

                                       18
<PAGE>
 
 Exhibit
 Number                                Name of Exhibit 
 ------                                ---------------               

     4.6  1996 Stock Option Plan (filed as Exhibit 4.5 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)

    10.1  Employment Agreement by and between the Company and Grizzle (filed as
          Exhibit 10.1 to the Company's Registration Statement on Form SB-2,
          file number 333-15139 and incorporated herein by reference)
 
    10.2  Employment Agreement by and between the Company and Johnson (filed as
          Exhibit 10.2 to the Company's Registration Statement on Form SB-2,
          file number 333-15139 and incorporated herein by reference)

    10.4  Employment Agreement by and between the Company and Motley (filed as
          Exhibit 10.4 to the Company's Registration Statement on Form SB-2,
          file number 333-15139 and incorporated herein by reference)

    10.5  Finders and Release Agreement, dated as of September 3, 1996, by and
          among the Company; Grizzle; CDI Acquisition JV, a Texas joint venture;
          and CD Partners JV, a Texas joint venture (filed as Exhibit 10.5 to
          the Company's Registration Statement on Form SB-2, file number 333-
          15139 and incorporated herein by reference)
 
    10.6  Asset Purchase Agreement, dated as of October 1, 1996, by and among
          Compact Discs International, Ltd., Kane and the Company (included
          herein as Exhibit 2.1)
 
    10.7  Asset Purchase Agreement, dated as of October 10, 1996, by and between
          MacDonald and the Company (included herein as Exhibit 2.2)
 
    10.8  Assignment and Assumption Agreement, dated as of October 10, 1996, by
          and between MacDonald and the Company (included herein as Exhibit 2.3)
 
    10.9  WCMA(R) Note, Loan and Security Agreement dated as of December 4,
          1997, between the Company and Merrill Lynch Business Financial
          Services Inc. (included herein as Exhibit 4.4)
 
   10.10  Term WCMA(R) Loan and Security Agreement dated as of November 28,
          1997, between the Company and Merrill Lynch Business Financial
          Services Inc. (included herein as Exhibit 4.5)
 
   10.11  Form of Franchise Agreement (filed as Exhibit 10.10 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)

   10.12  Form of Lockup Agreement (filed as Exhibit 10.11 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)
 
   10.13  Form of Partnership Agreement (filed as Exhibit 10.12 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)

   10.14  Form of Development Agreement (filed as Exhibit 10.13 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)

   10.15  Lease Agreement dated April 17, 1997 by and between Will Rogers
          Service Center Phase IV Associates and CD Warehouse, Inc. (filed as
          Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for the
          Quarter ended June 30, 1998 and incorporated herein by reference)

                                       19
<PAGE>
 
 Exhibit
 Number                                Name of Exhibit 
 ------                                ---------------                

   10.17  Agreement dated December 30, 1997, by and between Compact Discs
          Management, Inc. and Bruce D. MacDonald (filed as Exhibit 10.1 to the
          Company's Form 8-K dated January 1, 1998 and incorporated herein by
          reference)
 
   10.18  Asset Purchase Agreement dated as of January 1, 1998, by and among the
          Company; ZDTMAC; Compact Discs Management, Inc.; Texas ZDT Management,
          Ltd.; and the general and limited partners of Texas ZDT Management,
          Ltd. (filed as Exhibit 10.2 to the Company's Form 8-K dated January 1,
          1998 and incorporated herein by reference)

    21.1  List of subsidiaries (filed as Exhibit 21.1 to the Company's
          Registration Statement on Form SB-2, file number 333-15139 and
          incorporated herein by reference)

   27.1*  Financial Data Schedule
   
       *  Filed herewith.

(b)  No reports on Form 8-K were filed by the Company during the fourth quarter
     of the year ended December 31, 1997.

                                       20
<PAGE>
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.


March 12, 1998                    CD WAREHOUSE, INC.,
                                  a Delaware corporation



                                  /s/ Jerry W. Grizzle
                                  --------------------------------------
                                  Jerry W. Grizzle
                                  Chairman of the Board of Directors;
                                  President and Chief Executive Officer

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.


            NAME AND TITLE                                     DATE 
            --------------                                     ----

 
/s/ Jerry W. Grizzle                                        March 12, 1998
----------------------------------------------
Jerry W. Grizzle
   Chairman of the Board of Directors;
   President and Chief Executive Officer
 
 
/s/ Gary D. Johnson                                         March 12, 1998 
----------------------------------------------
Gary D. Johnson                                                
   Executive Vice President; Chief Operating
    Officer; Director


/s/ Doyle E. Motley                                         March 12, 1998
---------------------------------------------- 
Doyle E. Motley
   Sr. Vice President, Chief Financial Officer,
   Secretary and Treasurer

 
/s/ Christopher  M. Salyer                                  March 12, 1998 
---------------------------------------------- 
Christopher  M. Salyer                                         
   Director

 
/s/ Ronald V. Perry
----------------------------------------------              March 12, 1998 
Ronald V. Perry                                                
   Director

                                       21
<PAGE>
 
                                  APPENDIX A

                              CD Warehouse, Inc.

                         INDEX TO FINANCIAL STATEMENTS
                            AND SUPPLEMENTARY DATA

<TABLE>
<CAPTION>
                                                                                          PAGE
                                                                                          ----
<S>                                                                                       <C>
1.  Historical Financial Statements:

    (a) Financial Statements of CD Warehouse, Inc.

        (1)  Report of Independent Auditors.............................................. F-2
        (2)  Consolidated Balance Sheet at December 31, 1997............................. F-3
        (3)  Consolidated Statements of Operations for the year ended December
             31, 1997 and for the period from September 5, 1996 (inception) to
             December 31, 1996........................................................... F-4
        (4)  Consolidated Statements of Stockholders' Equity for the year ended
             December 31, 1997 and for the period from September 5, 1996
             (inception) to December 31, 1996............................................ F-5
        (5)  Consolidated Statements of Cash Flows for the year ended December
             31, 1997 and for the period from September 5, 1996 (inception) to
             December 31, 1996........................................................... F-6
        (6)  Notes to Consolidated Financial Statements.................................. F-8

    (b) Financial Statements of Compact Discs International, Ltd.

        (1)  Independent Auditors' Report................................................ F-21
        (2)  Balance Sheet at December 31, 1996.......................................... F-22
        (3)  Statement of Income for the year ended December 31, 1996.................... F-24
        (4)  Statement of Partners' Capital for the year ended December 31, 1996......... F-26
        (5)  Statement of Cash Flows for the year ended December 31, 1996................ F-27
        (6)  Notes to Financial Statements............................................... F-29

2.  Pro Forma Combined Condensed Statement of Operations for the year ended
    December 31, 1996.................................................................... F-35
</TABLE>

                                      F-1
<PAGE>
 
                         REPORT OF INDEPENDENT AUDITORS

The Stockholders
CD Warehouse, Inc.

We have audited the accompanying consolidated balance sheet of CD Warehouse,
Inc. as of December 31, 1997 and the related consolidated statements of
operations, stockholders' equity and cash flows for the year then ended and for
the period from September 5, 1996 (inception) to December 31, 1996. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of CD
Warehouse, Inc. at December 31, 1997 and the consolidated results of its
operations and its cash flows for the year then ended and for the period from
September 5, 1996 (inception) to December 31, 1996, in conformity with generally
accepted accounting principles.



                                    ERNST & YOUNG LLP

Oklahoma City, Oklahoma
February 27, 1998

                                      F-2
<PAGE>
 
                              CD Warehouse, Inc.

                          Consolidated Balance Sheet

<TABLE>
<CAPTION>
                                                                                  December 31,
                                                                                      1997
                                                                               ----------------
<S>                                                                            <C>
ASSETS
Current assets:
 Cash and cash equivalents                                                           $1,122,233
 Accounts receivable, net of allowance for doubtful accounts of $35,000                 517,248
 Merchandise inventory                                                                1,725,699
 Prepaid expenses and other                                                              53,816
                                                                               ---------------- 
Total current assets                                                                  3,418,996
 
Furniture, fixtures and equipment, net (Note 3)                                         499,845
Investment in unconsolidated partnerships                                                 6,009
Intangibles and other assets, net (Note 4)                                            3,438,299
                                                                               ----------------
Total assets                                                                         $7,363,149
                                                                               ================
 
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable                                                                    $1,107,669
 Accrued liabilities                                                                     85,438
 Advances and deposits                                                                   90,000
 Income taxes payable                                                                   205,000
                                                                               ---------------- 
Total current liabilities                                                             1,488,107
 
Deferred income taxes                                                                    25,000
Minority interest in partnerships                                                        97,398
Commitments (Note 7)
 
Stockholders' equity (Note 6):
 Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued
 Common stock, $.01 par value; 10,000,000 shares authorized, 1,820,000 shares
  issued and outstanding                                                                 18,200
 
 Additional paid-in capital                                                           5,348,543
 Retained earnings                                                                      385,901
                                                                               ----------------
Total stockholders' equity                                                            5,752,644
                                                                               ----------------
Total liabilities and stockholders' equity                                           $7,363,149
                                                                               ================
</TABLE>

See accompanying notes.

                                      F-3
<PAGE>
 
                              CD Warehouse, Inc.

                     Consolidated Statements of Operations

<TABLE>
<CAPTION>
                                                                                    PERIOD FROM   
                                                                                 SEPTEMBER 5, 1996
                                                                 YEAR ENDED       (INCEPTION) TO  
                                                              DECEMBER 31, 1997  DECEMBER 31, 1996 
                                                            -------------------------------------- 
<S>                                                         <C>                  <C>  
Revenues:
Company operations:
  Retail store sales                                                 $3,352,433           $     -- 
  Wholesale merchandise sales                                         3,902,729                 -- 
  Software income, net                                                   60,939                 -- 
 Franchise operations:
  Royalty income                                                      1,393,717                 -- 
  Franchise and development fees                                        263,500                 -- 
  Management fee                                                        115,728                 -- 
                                                            --------------------------------------  
Total revenues                                                        9,089,046                 --
 
Operating costs and expenses:
 Cost of sales--retail store sales                                    1,998,536                 -- 
 Cost of sales--wholesale merchandise sales                           3,608,480                 -- 
 Retail store operating expenses                                      1,225,987                 -- 
 General and administrative                                           1,509,672              2,335
 Depreciation and amortization                                          238,600                 -- 
 Minority interest in partnerships' income                               40,428                 -- 
                                                            --------------------------------------  
Total costs and expenses                                              8,621,703              2,335
                                                            --------------------------------------  
Operating income (loss)                                                 467,343            (2,335)
 
Other income:
 Equity in income of unconsolidated partnerships                        119,819                 --
 Interest income and other                                               29,037              2,037
                                                            --------------------------------------
                                                                        148,856              2,037
                                                            --------------------------------------
Income (loss) before income taxes                                       616,199              (298)
 
Provision for income taxes (Note 5)                                     230,000                --
                                                            -------------------------------------- 
Net income (loss)                                                    $  386,199           $  (298)
                                                            ======================================
 
Net income per share--basic and diluted                                   $0.23               $--
                                                            ====================================== 
 
Shares used in computation                                            1,714,790            350,000
                                                            ======================================
</TABLE>

See accompanying notes.

                                      F-4
<PAGE>
 
                              CD Warehouse, Inc.

                Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>
                                                                        ADDITIONAL
                                               COMMON STOCK              PAID-IN         RETAINED
                                    --------------------------------
                                          SHARES          AMOUNT         CAPITAL         EARNINGS
                                    ----------------------------------------------------------------
<S>                                   <C>             <C>             <C>             <C> 
Balance at September 5, 1996                      --        $     --        $     --         $    --

Sale of common stock                         350,000           3,500         346,500              --
 
Net loss                                          --              --              --            (298)
                                    ---------------------------------------------------------------- 
Balance at December 31, 1996                 350,000           3,500         346,500            (298)
 
Exercise of stock subscription               350,000           3,500         346,500              --
 
Sale of common stock (net of
 offering costs)                           1,040,000          10,400       4,256,343              --
 
Issuance of common stock in
 exchange for partnership interests           80,000             800         399,200              --
 
Net income                                        --              --              --         386,199
                                    ----------------------------------------------------------------
Balance at December 31, 1997               1,820,000         $18,200      $5,348,543        $385,901
                                    ================================================================
</TABLE>

See accompanying notes.

                                      F-5
<PAGE>
 
                               CD Warehouse, Inc.

                     Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                                              PERIOD FROM   
                                                                                           SEPTEMBER 5, 1996
                                                                           YEAR ENDED       (INCEPTION) TO  
                                                                       DECEMBER 31, 1997   DECEMBER 31, 1996
                                                                     -------------------- ------------------  
<S>                                                                  <C>                   <C>               
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)                                                       $   386,199              $ (298)
Adjustments to reconcile net income (loss) to net cash used                         
 for operating activities:                                                          
  Depreciation and amortization                                             238,600                  --
  Deferred income taxes                                                      25,000                  --
  Gain on disposal of assets, net                                           (21,432)                 -- 
  Net changes in operating assets and liabilities,                                  
   exclusive of business acquisitions:                                              
     Accounts receivable, net                                              (444,509)                 --
     Inventories                                                         (1,287,056)                 --
     Prepaid expenses and other                                             (53,816)                 --
     Investment in partnerships                                              52,953                  --
     Other assets                                                           (52,731)                 --
     Accounts payable                                                       564,440                  --
     Accrued liabilities                                                     83,765                  --
     Advances and deposits                                                   90,000                  --
     Income taxes payable                                                   205,000                  --
     Minority interest                                                       84,418                  --
                                                                     -------------------- ------------------  
Total adjustments                                                          (515,368)               (298)
                                                                     -------------------- ------------------  
Net cash used for operating activities                                     (129,169)               (298)

</TABLE>

(Continued on following page)

                                      F-6
<PAGE>
 
                               CD Warehouse, Inc.

               Consolidated Statements of Cash Flows (continued)


<TABLE>
<CAPTION>
                                                                                              PERIOD FROM   
                                                                                           SEPTEMBER 5, 1996
                                                                           YEAR ENDED       (INCEPTION) TO  
                                                                       DECEMBER 31, 1997   DECEMBER 31, 1996
                                                                     -------------------- ------------------  
<S>                                                                  <C>                   <C>               
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of furniture, fixtures and equipment                           $  (535,426)         $      --
Proceeds from disposal of assets                                             179,012
Organizational costs                                                            (775)           (12,847)
Acquisition of businesses:
 Excess of purchase price over assets acquired                            (3,138,756)          (220,151)
 Accounts receivable                                                         (72,739)                --
 Inventory                                                                  (398,346)                --
 Furniture, fixtures and equipment                                           (50,514)                --
 Investment in partnerships                                                  (21,452)                --
 Other assets                                                                   (931)                --
 Accounts payable                                                            543,229                 --
 Accrued liabilities                                                           1,673                 --
 Minority interest                                                            12,980                 --
                                                                     ---------------      -------------             
Net cash used for investing activities                                    (3,482,045)          (232,998)

CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from sale of common stock                                         4,368,016            350,000
Deferred offering costs                                                                        (101,273)
Exercise of stock subscription                                               350,000                 --
                                                                     ---------------      -------------        
Net cash provided by financing activities                                  4,718,016            248,727
                                                                     ---------------      -------------        
Net increase in cash and cash equivalents                                  1,106,802             15,431
 
Cash and cash equivalents at beginning of period                              15,431                 --
                                                                     ---------------      -------------      
Cash and cash equivalents at end of period                               $ 1,122,233          $  15,431
                                                                     ===============      =============
</TABLE>

See accompanying notes.

                                      F-7
<PAGE>
 
                               CD Warehouse, Inc.

                   Notes to Consolidated Financial Statements

                               December 31, 1997


1. Summary of Significant Accounting Policies

ORGANIZATION AND OPERATIONS

CD Warehouse, Inc. and its wholly-owned subsidiary, Compact Discs Management,
Inc. (together the "Company") are engaged in the franchising and ownership of
music stores offering new and preowned compact discs and related products. The
Company was formed in Delaware on September 5, 1996 and had only limited
operations prior to its initial public offering and simultaneous business
acquisition in January 1997 (Note 2). At December 31, 1997, the Company operates
16 Company and majority-owned partnership retail music stores located throughout
the United States and has 134 franchised stores throughout the United States,
England, France and Venezuela.

PRINCIPLES OF CONSOLIDATION

The accompanying consolidated financial statements include the accounts of the
Company and majority-owned retail music stores, organized principally as general
partnerships. All significant intercompany accounts and transactions have been
eliminated. Investments in minority-owned retail music stores, organized
principally as general partnerships, are carried at equity.

USE OF ESTIMATES

The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results inevitably will differ from those estimates,
and such differences may be material to the financial statements.

CASH EQUIVALENTS

Cash equivalents include money-market investments with maturities of three
months or less when purchased.

FURNITURE, FIXTURES AND EQUIPMENT

Furniture, fixtures and equipment, including leasehold improvements, are
recorded at cost and are depreciated on a straight-line basis over the estimated
useful lives of the assets which range from five to ten years. Depreciation
expense in 1997 totaled $63,185.

                                      F-8
<PAGE>
 
                               CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


1. Summary of Significant Accounting Policies (continued)

INVENTORY

Inventory consists of new and preowned compact discs and is recorded at the
lower of average cost or market.

FRANCHISE FEES AND ROYALTIES

Initial franchise fees are nonrefundable and are recognized in income when all
material services or conditions relating to the sale of the franchise have been
substantially performed or satisfied by the Company. Area development fees are
nonrefundable and are recognized in income on a pro rata basis when the
conditions for revenue recognition under the individual development agreements
are met. Royalties from franchise operations are recognized in income as earned.

ADVERTISING COSTS

Costs incurred in connection with advertising and promotion of the Company's
products are expensed as incurred. Such costs amounted to $131,000 and none in
1997 and 1996, respectively.

STOCK OPTIONS

The Company accounts for employee stock-based compensation using the intrinsic
value method prescribed by Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations. No
compensation expense is recorded with respect to stock options granted at prices
equal to the market value of the Company's common stock at the date of grant.
Upon exercise, the excess of the proceeds over the par value of the shares
issued is credited to additional paid-in capital.

                                      F-9
<PAGE>
 
                               CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

NET INCOME PER SHARE

The Company accounts for earnings per share in accordance with Statement of
Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"), which
defines the method used to compute earnings per share. Weighted average common
shares outstanding used in the calculation of basic earnings per share for the
year ended December 31, 1997 totaled 1,711,123. Common shares used in the
calculation of diluted earnings per share for the year ended December 31, 1997
was 1,714,790. The difference in the number of shares for 1997 is attributable
to dilutive stock options. See Note 6 for a description of potentially dilutive
securities of the Company.

SUPPLEMENTAL CASH FLOW INFORMATION

For the year ending December 31, 1997, the Company had the following noncash
investing and financing activities:

     Purchased franchise interests of Company franchisee (Note 2) for 80,000
     shares of the Company's common stock valued at the initial public offering
     price of $5.00 per share:

<TABLE>
       <S>                                                     <C>             
       Costs in excess of net assets acquired, net                      $301,806
       Inventory                                                          40,297
       Furniture, fixtures and equipment                                  18,800
       Investment in partnerships                                         37,510
       Other assets                                                        1,587
                                                               -----------------
                                                                        $400,000
                                                               =================
</TABLE>

2. INITIAL PUBLIC OFFERING AND BUSINESS ACQUISITIONS

Effective September 5, 1996 and October 1, 1996, the Company obtained stock
subscription agreements for the sale of an aggregate of 700,000 shares of common
stock at $1 per share. During October 1996, the Company received $350,000 in
cash in exchange for the issuance of 350,000 shares of common stock. The
remaining 350,000 shares under the subscription agreement were paid for
concurrently with the closing of the Company's initial public offering of common
stock.

                                      F-10
<PAGE>
 
                               CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)

2. Initial Public Offering and Business Acquisitions (continued)

In January 1997, the Company completed an Initial Public Offering ("Offering")
for 1,000,000 shares of its common stock at a price of $5 per share. In March
1997, the underwriters exercised an overallotment option and purchased an
additional 40,000 shares of common stock at $5 per share. The proceeds of the
Offering, after deducting the underwriting discount and offering expenses were
approximately $4.3 million.

Simultaneously with the closing of the Offering, the Company purchased
substantially all of the assets of Compact Discs International, Ltd. ("CDIL")
for $3.2 million. Prior to the acquisition, CDIL was engaged principally in the
business of selling new and preowned audio compact discs to its franchisees.

Also in January 1997, the Company purchased all of the franchise interests of
the largest CDIL franchisee in exchange for 80,000 shares of the Company's
common stock.

The acquisitions were recorded in January 1997 under the purchase method of
accounting and resulted in an excess of purchase price over net assets acquired
of approximately $3.5 million which is amortized on a straight-line basis over
20 years. Amortization of goodwill totaled $175,415 in 1997.

The following unaudited pro forma combined information presents a summary of the
consolidated results of operations of the Company and the acquired businesses
for 1996 as if the acquisitions and the initial public offering of the Company
had occurred January 1, 1996.

<TABLE>
     <S>                                                       <C>
     Revenues                                                  $5,005,623
     Net income                                                $  175,959
     Net income per share--basic                               $      .10
     Shares used in computation                                 1,820,000 
</TABLE>

                                      F-11
<PAGE>
 
                               CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued) 


2. INITIAL PUBLIC OFFERING AND BUSINESS ACQUISITIONS (CONTINUED)

These unaudited pro forma results have been prepared for comparative purposes
only and include certain adjustments, including amortization of goodwill and
provision for executive compensation as a result of the acquisitions. They do
not purport to be indicative of the results of operations which would have
resulted had the acquisitions and initial public offering occurred on January 1,
1996, or of future results of operations of the consolidated entities.

3. FURNITURE, FIXTURES AND EQUIPMENT

Furniture, fixtures and equipment, including leasehold improvements, are located
at the following leased facilities at December 31, 1997:

<TABLE>
     <S>                                                             <C>  
     Corporate headquarters                                            $178,812
     Retail stores                                                      406,610
                                                                     ----------
                                                                        585,422
     Accumulated depreciation                                            85,577
                                                                     ----------
                                                                       $499,845
                                                                     ==========
</TABLE>

4. INTANGIBLES AND OTHER ASSETS

Intangibles and other assets consist of the following at December 31, 1997:

<TABLE>
     <S>                                                             <C>
     Excess of purchase price over net assets acquired in business      
      acquisitions                                                   $3,539,719
     Organization costs                                                  13,622 
     Deposits and other                                                  55,249
                                                                     ----------
                                                                      3,608,590
     Accumulated amortization                                           170,291
                                                                     ----------
                                                                     $3,438,299
                                                                     ==========
</TABLE>

Organization costs are amortized over 15 years. Goodwill resulting from business
and store acquisitions is amortized over 20 years.

                                      F-12
<PAGE>
 
                               CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)  


5. INCOME TAXES

The significant components of income tax expense for the year ended December 31,
1997 are as follows:

<TABLE>
     <S>                                                         <C>                                        
     Current tax expense:                                                                                  
      Federal                                                        $180,000                              
      State                                                            25,000                              
                                                                 ------------
                                                                      205,000                              
                                                                                                           
     Deferred tax expense:                                                                                 
      Federal                                                          22,000                              
      State                                                             3,000                              
                                                                 ------------
                                                                       25,000                              
                                                                 ------------
                                                                     $230,000                              
                                                                 ============
</TABLE>

The provision for income taxes differs from the computed "expected" income tax
provision using federal statutory rates on income before income taxes for the
following reasons:

<TABLE>
<CAPTION>
                                                                 YEAR ENDED                           
                                                                DECEMBER 31,                          
                                                                    1997                              
                                                             ----------------                         
     <S>                                                     <C>                                    
     Computed "expected" income tax                                  $209,508                         
     Increases in taxes resulting from:                                                               
      State income taxes, net of federal benefit                       18,488                         
      Other                                                             2,004                         
                                                             ----------------
                                                                     $230,000                         
                                                             ================                         
</TABLE>                                                                     

Deferred income taxes and deferred tax liability at December 31, 1997 of $25,000
result from differences in amortization and depreciation of intangibles and
furniture and fixtures for financial and tax purposes.

                                      F-13
<PAGE>
 
                               CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)  


6. STOCKHOLDERS' EQUITY

STOCK OPTION PLAN

On December 10, 1996, the Company adopted the 1996 Stock Option Plan which
provides for grants of up to 400,000 shares of common stock to certain
employees, officers, directors and others. Generally, the purchase price of
stock issuable upon exercise of the options will be at least equal to the fair
market value of the stock on the dates of grant. Generally, options are
exercisable no longer than ten years from the dates of grant. The Company has
agreed to grant options to purchase 6,000 shares annually, subject to pro-rata
vesting over a three-year period, to each director. No options were granted
through December 31, 1996. In 1997, options to acquire 236,000 common shares
were granted at option prices equal to the fair market value of the common stock
on the date of grant.

                                      F-14
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


Stock option transactions for 1997 are summarized as follows:

<TABLE>
<CAPTION>
                                                                                       WEIGHTED
                                                                                       AVERAGE
                                                                                       EXERCISE 
                                                                       SHARES            PRICE
                                                                  ---------------------------------
       <S>                                                        <C>                  <C>  
       Outstanding at beginning of year                                    -
       Granted                                                       236,000           $3.85
       Exercised                                                           -
       Canceled                                                            -
                                                                  ----------
       Outstanding at end of year                                    236,000           $3.85
                                                                  ==========
                                              
       Exercisable at end of year                                          -
                                                                  ==========
 
       Weighted average fair value of options granted during year   $   2.18
                                                                  ==========
</TABLE>

Outstanding options to acquire 236,000 shares of stock at December 31, 1997 had
exercise prices ranging from $3.13 to $5.00 per share and had a weighted average
remaining contractual life of ten years.

The following pro forma information, as required by Statement of Financial
Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS
123"), presents net income and earnings per share information as if the Company
had accounted for stock options issued in 1997 using the fair value method
prescribed by the Statement. The fair value of issued stock options was
estimated at the date of grant using a Black-Scholes option pricing model with
the following assumptions for 1997: weighted average risk-free interest rate of
5.81%; no dividends over the option term; stock price volatility factor of .599,
and a weighted average expected option life of five years. The estimated fair
value as determined by the model is amortized to expense over the respective
vesting period. The SFAS 123 pro forma information presented below is not
necessarily indicative of the pro forma effects to be presented in future
periods.

                                     F-15
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


The SFAS 123 pro forma information is as follows:

<TABLE>
<CAPTION>
                                                               YEAR ENDED
                                                            DECEMBER 31, 1997
                                                          -------------------
          <S>                                             <C>
          Net income                                              $349,627   
          Net income per share                                    $    .20   
</TABLE>

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of fair value of its stock options.

WARRANTS

In connection with the Offering, the Company sold to the underwriters, for a
price of $.001 per warrant, warrants to purchase 100,000 shares of common stock.
The underwriters' warrants are exercisable at $7.50 per share through January
2002.

                                     F-16
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


7. COMMITMENTS

Effective in January 1997, after the Company's completion of the Offering, the
Company entered into employment agreements with three officers of the Company.
The employment agreements are for terms of one and five years with renewal
options of one and five years and total $255,000 annually for the three
individuals.

The Company has entered into operating leases primarily for its retail store
locations and corporate facilities. Rental expense under these leases totaled
$301,621 for 1997. Total rental amounts of $1,176,393 under these noncancelable
leases are due as follows: 1998--$379,367, 1999--$354,199, 2000--$274,466, 2001-
-$109,361 and 2002--$59,000.

                                     F-17
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


8. RELATED PARTY TRANSACTIONS

Pursuant to the purchase agreement with a predecessor franchisee (Note 2), the
franchisee served as an officer of the Company and continued to provide
accounting services for the acquired franchise interests. The Company
compensated the officer for these accounting services and reimbursed certain
agreed upon office expenses. Amounts paid under this agreement totaled $109,288
in 1997. In December 1997, the individual resigned his position with the Company
and repurchased certain franchise interests from the Company. Total proceeds of
this sale amounted to $170,000 which approximated book value at the time of
sale. Additionally, the Company has entered into a consulting arrangement with
the individual, expiring in March 1998, providing for consideration of $30,000.

The business acquisition (Note 2) resulted in the Company entering into an area
development agreement (the "ADA") with the principal owner of CDIL (also a
stockholder of the Company). The ADA provides for the right to develop franchise
operations worldwide, except for the United States, Canada and Mexico. The
Company has the right, during a specified period of time, to cancel the ADA and
to acquire any franchise developed under the ADA at a specified multiple of
earnings. In addition, the Company has agreed to grant to the individual (1) ten
domestic franchises with no initial franchise fee and royalties of 2% of net
sales and (2) two renewal franchises with no franchise fee or royalty payments.
Except as provided for in the above mentioned franchise agreements, CDIL and the
individual have also entered into covenants not to compete with the Company for
a period of ten years.

                                     F-18
<PAGE>
 
                              CD Warehouse, Inc.

            Notes to Consolidated Financial Statements (continued)


9. SUBSEQUENT EVENTS

In January 1998, the Company purchased five stores from a franchisee for cash of
$211,030 and 100,000 shares of common stock valued at $3.625 per share for a
total purchase price of $573,530.

In February 1998, the Company finalized a $500,000 Line of Credit and $500,000
Term Loan Agreement ("Agreement") with Merrill Lynch Business Financial
Services, Inc. Amounts borrowed under the Line of Credit or Term Loan will bear
an interest rate equal to the sum of 3.1% and the thirty-day Commercial Paper
Rate. This Agreement replaced a credit facility with another financial
institution which existed, but was unused, as of December 31, 1997.

                                     F-19
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.

                             Financial Statements

                     FOR THE YEAR ENDED DECEMBER 31, 1996

                                     WITH

                         INDEPENDENT AUDITORS' REPORT

                                      F-20
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT


To the General Partner
Compact Discs International, Ltd.

     We have audited the accompanying balance sheet of Compact Discs
International, Ltd. (A Texas Limited Partnership) as of December 31, 1996, and
the related statements of income, partners' capital, and cash flows for the year
then ended.  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 financial position of Compact Discs International,
Ltd. as of December 31, 1996 and the results of its operations and its cash
flows for the year then ended in conformity with generally accepted accounting
principles.

                                             Huselton & Morgan, P.C.
                                             Dallas, TX
                                             February 27, 1997

                                      F-21
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.

                         (A Texas Limited Partnership)

                                 BALANCE SHEET

                               DECEMBER 31, 1996
                                        


                                    ASSETS
                                        
<TABLE>
<S>                                                    <C>
Current assets
 Cash                                                  $  525,523
 Accounts receivable (net of allowance of $132,253)       341,414
 Inventory                                                326,561
 Prepaid expenses                                          31,090
 Deferred expenses                                         69,125
                                                       ----------
     Total current assets                               1,293,713
                                                       ----------
Furniture, fixtures and equipment (net of
 accumulated depreciation)                                 32,615
                                                       ----------
Investment in partnerships                                 61,992
Other assets (net of amortization)                          3,358
                                                       ----------
     Total other assets                                    65,350
                                                       ----------
        Total assets                                   $1,391,678
                                                       ==========
</TABLE>

                  THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
                        OF THESE FINANCIAL STATEMENTS.

                                      F-22
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.
                         (A Texas Limited Partnership)
                                 BALANCE SHEET
                               DECEMBER 31, 1996
                                        


                       LIABILITIES AND PARTNERS' CAPITAL


<TABLE>
<S>                                             <C>
Current liabilities
 Accounts payable                               $  716,550
 Sales tax payable                                   1,450
 Payroll taxes payable                                 128
 Refundable development fees                         7,500
 Deposit on asset sale                             100,000
                                                ----------
   Total current liabilities                       825,628
                                                ----------
Partners' capital                                  566,050
                                                ----------
     Total liabilities and partners' capital    $1,391,678
                                                ==========
</TABLE>

Contingent liabilities


                  THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
                        OF THESE FINANCIAL STATEMENTS.

                                      F-23
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.

                         (A Texas Limited Partnership)

                              STATEMENT OF INCOME

                     FOR THE YEAR ENDED DECEMBER 31, 1996

<TABLE>
Revenue
<S>                                 <C>
 Retail sales                       $3,468,879
 Royalty income                      1,200,396
 Franchise fees                         65,000
 Development fees                       23,321
 Computer/software income                7,029
                                    ----------
   Total revenue                     4,764,625
                                    ----------
Expenses
 Cost of goods sold-retail sales     3,276,953
 Salaries                              299,969
 Bad debts                             150,030
 Professional fees                      64,120
 Promotion                              40,003
 Taxes                                  34,028
 Travel                                 31,949
 Telephone & utilities                  31,415
 Commissions                            29,008
 Rent                                   28,515
 Insurance                              20,144
 Office expense                         18,616
 Printing                               16,970
 Depreciation                           12,782
 Postage                                 8,907
 Entertainment                           5,633
 Franchise meeting                       5,388
 Repairs & maintenance                   5,041
 Auto expense                            4,805
 Licenses                                4,170
 </TABLE>
 
                                  (continued)
                  THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
                        OF THESE FINANCIAL STATEMENTS.

                                      F-24
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.

                         (A Texas Limited Partnership)

                              STATEMENT OF INCOME

                     FOR THE YEAR ENDED DECEMBER 31, 1996

                                  (continued)
<TABLE>
<CAPTION>
 
 
Expenses
<S>                          <C>
 Miscellaneous                    3,571
 Contract labor                   3,038
 Advertising                      2,495
 Dues & subscriptions             1,407
 Supplies                         1,240
 Bank charges                     1,080
 Amortization                       456
 Photography                        140
 Charitable contributions           140
 Interest expense                    51
                             ----------
   Total expenses             4,102,064
                             ----------
Operating income                662,561
Other income
 Gain on sale of assets          13,835
 Investment income               43,924
 Interest income                     72
                             ----------
   Net income                $  720,392
                             ==========
</TABLE>

                  THE ACCOMPANYING NOTES ARE AN INTEGRAL PART
                         OF THESE FINANCIAL STATEMENTS.

                                      F-25
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.
                       
                         (A Texas Limited Partnership)
                         
                        STATEMENT OF PARTNERS' CAPITAL
                        
                               DECEMBER 31, 1996
                                        
<TABLE>
<S>                                    <C>
Beginning balance                      $ 430,239
 
Beginning capital - CD Acquisitions      128,096
 
Net income                               720,392
 
Distributions
 Cash                                   (508,609)
 Noncash                                (204,068)
                                       ---------
 
Ending balance                         $ 566,050
                                       =========
 
</TABLE>

                     THE ACCOMPANYING NOTES ARE AN INTEGRAL
                      PART OF THESE FINANCIAL STATEMENTS.

                                      F-26
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.
                         (A Texas Limited Partnership)
                            STATEMENT OF CASH FLOWS
                               DECEMBER 31, 1996
                                        

<TABLE>
<S>                                                    <C>       <C> 
Cash flows from operating activities:
   Net income                                                    $ 720,392

 Noncash items
   Bad debt expense                                                138,629
   Depreciation and amortization                                    13,238 
   Investment income                                               (43,924)
   Gain on sale of investment                                      (13,835) 
 Adjustments to reconcile net income to cash
   used by operating activities
     (Increase) in accounts receivable                            (265,127)
     (Increase) in inventory                                       (20,804)
     (Increase) in prepaids and deferred expenses      (91,123)
     Increase in accounts payable                                  291,983
     Decrease in accrued expenses                                  (64,294)
     Increase in deposit on sale                                   100,000
                                                                 ---------
        Net cash provided by operating activities      765,135

Cash flows from investing activities
 Purchase of fixed assets                                          (14,661)
 Proceeds from sale of asset                                         4,000
 Contribution to partnership                                        (1,600)
 Proceeds from sale of Fort Worth investment            30,925
 Distributions from partnerships                                    42,394
                                                                 ---------
        Net cash provided by investing activities       61,058
 
</TABLE>

                                  (continued)


                     THE ACCOMPANYING NOTES ARE AN INTEGRAL
                      PART OF THESE FINANCIAL STATEMENTS.

                                      F-27
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.
                         (A Texas Limited Partnership)
                            STATEMENT OF CASH FLOWS
                               DECEMBER 31, 1996
                                  (continued)

<TABLE>
<S>                                              <C>            <C> 
Cash flows from financing activities
 Distributions to partners                                       (508,609)
                                                                ---------
        Net cash used by financing activities     (508,609)
Net increase in cash                                              317,584
Cash from merger of CDA                                           159,444
Cash at beginning of year                                          48,495
                                                                ---------
Cash at end of year                                             $ 525,523
                                                                =========
 
Interest paid                                    $      51
                                                 =========
</TABLE> 
 

Supplemental notes to cash flow
-------------------------------
   In November, 1996, the Company sold a portion of its interest in the  Fort
Worth store to the Company's partners and recorded the sale of $30,636 as a draw
to the partners.

   Accounts receivable due from partners of the Company in the amount of
$173,432 were discharged and recognized as a distribution to the partners.

   Accounts receivable in the amount of $35,549 from two franchisees were
exchanged for partnership interests.

                    The accompanying notes are an integral
                      PART OF THESE FINANCIAL STATEMENTS.

                                      F-28
<PAGE>
 
                       COMPACT DISCS INTERNATIONAL, LTD.
                         (A Texas Limited Partnership)
                               December 31, 1996
                         NOTES TO FINANCIAL STATEMENTS
                                        
1.  Organization
    ------------

     The Company
     -----------

     Compact Discs International, Ltd. (the "Company") is a Texas limited
partnership which conducts business under the name "CD Warehouse" and maintains
its principal office in Richardson, Texas.

     In 1995, the Company purchased an 81.25% ownership in CD Warehouse Fort
Worth and consolidated the financial results of this entity with the Company.
This interest was sold during 1996.

     Effective January 1, 1996, CD Acquisitions ("CDA"), a joint venture owned
and operated by the Company's partners, was merged into the Company.

     The Company offers and sells single-unit franchises and development rights
for multi-unit franchises for the operation of retail sales outlets which buy,
sell and trade new and used compact discs and related items.  As of December 31,
1996, the Company has executed 118 franchise agreements for the operation of
stores, of which 113 are operational.  The Company has 3 development agreements
in place as of December 31, 1996.  Effective with the merger of CDA, the Company
began selling new and used compact discs to franchisees.

     Cash and cash equivalents
     -------------------------

     For purposes of the statement of cash flows, the Company considers all
highly liquid debt instruments purchased with a maturity of three months or less
to be cash equivalents.  All cash is held in accounts that are federally
insured.

     Inventory
     ---------

     Inventory consists primarily of both new and used compact discs.  All
inventory is valued at the lower of cost or market using the first-in, first-out
(FIFO) method.

     Furniture, fixtures and equipment
     ---------------------------------

     Furniture, fixtures and equipment are stated at cost.  The provision for
depreciation has been calculated using the straight-line method.  Useful lives
range from 3 to 7 years.

                                      F-29
<PAGE>
 
     Other assets
     ------------

     Organization costs and the Company's trademark are being amortized using
the straight-line method over five and fifteen years, respectively.

     Investment in partnerships
     --------------------------

     The Company records its ownership in four partnerships that own CD
Warehouse stores using the equity method of accounting.

     Revenue recognition
     -------------------

     Franchise fees are non-refundable.  Franchise fee income is recognized upon
the opening of the related store.  The Company's commitment and obligations to
franchisees are not significant after the store is opened.  Development right
fees paid are recognized as income on a prorated basis as franchise units within
a development agreement are opened.  Development fees are non-refundable, but
can be applied against future franchise fees and royalty fees due from
development franchisees.  Royalties are recognized when earned.  Specially
designed software and computer equipment are sold to the franchisees, and the
related income is recognized when earned.

     Estimates
     ---------

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect certain reported amounts and disclosures.  Accordingly,
actual results may differ from those estimates.

2.  Furniture, fixtures and equipment
    ---------------------------------

     Components of furniture, fixtures and equipment at December 31, 1996 are as
follows:

<TABLE>
     <S>                                                               <C>   
     Equipment                                                         $ 31,607 
     Furniture and fixtures                                               9,685 
     Automobiles                                                         16,528 
     Leasehold improvements                                                   0
                                                                       -------- 
         Total                                                           57,820
     Accumulated depreciation                                           (25,205)
                                                                       --------
         Total                                                         $ 32,615
                                                                       ========
</TABLE> 

3.  Other assets
    ------------

<TABLE> 
     <S>                                                               <C> 
     Components of other assets at December 31, 1996 are as follows:
     Deposits                                                          $  2,087
     Organization costs                                                   2,150
     Trademark                                                              394
                                                                       --------
</TABLE> 

                                      F-30
<PAGE>
 
<TABLE> 
     <S>                                                              <C>       
         Total                                                           4,631  
     Accumulated amortization                                           (1,273)
                                                                      --------  
         Total                                                        $  3,358  
                                                                      ======== 
</TABLE>

4.  Investments in partnerships
    ---------------------------

     In the latter part of 1995 and in 1996, the Company entered into
partnership agreements to own and operate retail CD outlets in Tulsa, Oklahoma;
Memphis, Tennessee; Orange Park, Florida; and Edmond, Oklahoma.  At December 31,
1996, the Company has the following investments in general partnerships:

<TABLE>
<CAPTION>
                                                     Percentage
          Partnership                                  Owned
          -----------                                ----------
     <S>                                             <C>
     CD Warehouse - Tulsa                               50
     CD Warehouse - Memphis                             25
     CD Warehouse - Orange Park                         50
     CD Warehouse - Edmond                              50
</TABLE>

                                      F-31
<PAGE>
 
     At December 31, 1996, the Company's investments in partnerships and equity
in the income of these partnerships for the year ended December 31, 1996 consist
of the following:

<TABLE>
<CAPTION>

                                         Investment in    
          Partnership                     Partnership      Income    
                                        --------------  ------------ 
          <S>                           <C>             <C>          
          CD Warehouse - Tulsa                $25,191       $10,238  
          CD Warehouse - Memphis                  (88)        8,858
          CD Warehouse - Orange Park           21,886        10,886
          CD Warehouse - Edmond                15,003          (546)
          CD Warehouse - Fort Worth                 0        14,488
                                            ---------       ------- 

                                            $  61,992       $43,924
                                            =========       =======
</TABLE> 


     The following summarizes the activity of the CD Warehouse equity
investments of the Company for the year ended December 31, 1996:

<TABLE>
<CAPTION>
                     CD Warehouse   CD Warehouse  CD Warehouse  CD Warehouse
                        Edmond      Orange Park      Tulsa        Memphis
                     -------------  ------------  ------------  ------------
<S>                  <C>            <C>           <C>           <C>
Total assets              $42,505       $ 74,854      $ 64,815      $ 49,728
Total liabilities           3,497          4,080         4,430         4,084
                          -------       --------      --------      --------
     Net assets           $39,008       $ 70,774      $ 60,385      $ 45,644
                          =======       ========      ========      ========
Revenues                  $78,670       $260,705      $261,873      $371,627
                          =======       ========      ========      ========
Net income (loss)         $(1,091)      $ 21,772      $ 20,475      $ 35,430
                          =======       ========      ========      ========
</TABLE>

5.  Commitments and contingencies
    -----------------------------

     The Company leases office space under a non-cancelable operating lease
agreement.  The agreement expires in 1997.  Total rent expense for the year
ended December 31, 1996 was $28,515.

     The following is a schedule of future minimum lease payments for the above
lease as of December 31, 1996:

               1997                          $   5,694
                                             =========

                                      F-32
<PAGE>
 
     At December 31, 1996, the Company is involved in one situation of pending
litigation. The case involves a wrongful death claim resulting from an accident
at a franchise location. Although the Company does not anticipate a loss in this
case, the extent of possible damages cannot be accurately determined at this
time.

6.  Income taxes
    ------------

     Taxable income of the Company is includable in the income returns of the
individual partners; therefore, no provision for income taxes has been made in
the accompanying financial statements.

7.  Related-party transactions
    --------------------------

     The  Company sells new and used merchandise to franchisees.  The
franchisees included the CD Warehouse investments listed in Note 4.  Sales to
these franchisees amounted to $124,796 for the year ending December 31, 1996.

     At December 31, 1996, the accounts receivable balance includes $12,084 of
receivables due from franchisees who are relatives of the partners.

8.  Pooling-of-interest
    -------------------

     Effective January 1, 1996, CD Acquisitions (A Joint Venture) was merged
into the Company.  As a result of the merger, Compact Discs International, Ltd.
became the successor in interest of all rights, properties, assets, and
liabilities of CDA.

     The 1996 financial statements for the merged entities reflect the merger as
a pooling of interest.  The 1996 statements reflect a full year of operations.

9.  Concentration of credit risk
    ----------------------------

     The Company maintains its cash balances at various financial institutions
located in the Dallas, Texas area.  Cash and cash equivalents are held in bank
accounts that are insured by the Federal Deposit Insurance Corporation up to
$100,000.  At December 31, 1996, the Company's uninsured balances, before
reconciling items, totaled $423,750.

                                      F-33
<PAGE>
 
10.  Fair value of financial instruments
     -----------------------------------

      The estimated fair values of the Company's financial instruments, none of
which are held for trading purposes, as of December 31, 1996 are as follows:

<TABLE> 
<CAPTION> 
                                        Carrying      Fair
                                         Amount      Value
                                        --------    -------
     <S>                                <C>        <C> 
     Assets:
      Cash and equivalents              $525,523   $525,523
      Investments in partnerships       $ 61,992   $ 61,992
</TABLE> 

11.  Subsequent events
     -----------------

      Effective January 22, 1997, the Company sold a substantial portion of its
assets to an unrelated third party.  The assets sold consist of all of the
Company's (a) rights as the franchisor under existing franchise agreements and
existing area development agreements; (b) inventory of new and used CD's; (c)
accounts, notes and warranty receivables; (d) trademarks and other intellectual
property rights; (e) business records, including but not limited to the
Company's customer lists, vendor lists, prospective franchise lists, franchise
files, accounting and tax records concerning the same, sales literature and
promotional materials; (f) software programs; (g) furniture, equipment, files
and other assets located at the Company's corporate offices; and (h) the equity
interests of the Company in CD Warehouse stores in Tulsa, Oklahoma, (two),
Edmond, Oklahoma and Memphis, Tennessee.  The purchaser will be entitled to all
franchise fees and royalties accruing to the Company after the closing date of
the acquisition.  As part of the acquisition, the purchaser will assume the
Company's accounts payable for the inventory being acquired as of the closing
date, as well as the Company's obligations under the franchise agreements and
franchise and area development agreements.  The Company will continue in
existence; however, the Company's primary business activities remain
undetermined.

      In a separate transaction dated February 1, 1997, the Company sold its
interest in the CD Warehouse - Orange Park investment for $45,000.

                                      F-34
<PAGE>
 
                              CD WAREHOUSE, INC.
              PRO FORMA COMBINED CONDENSED STATEMENT OF OPERATIONS
                          Year Ended December 31, 1996
                                  (unaudited)

<TABLE>
<CAPTION>


                                                   Historical
                                     --------------------------------------                              
                                                     Compact
                                         CD           Discs
                                     Warehouse,   International,    MacDonald    Pro Forma
                                        Inc.           Ltd.          Assets     Adjustments      Pro Forma
                                     ----------------------------------------------------------------------
<S>                                  <C>          <C>               <C>        <C>              <C>
Revenues:
   Company operations:
   Retail store sales                $        -      $      -       $ 240,998                    $  240,998
   Wholesale merchandise sales                -        3,468,878         -                        3,468,878
   Software income, net                       -            7,030         -                            7,030
   Franchise operations:
   Royalty income                             -        1,200,396         -                        1,200,396
   Franchise and development fees             -           88,321         -                           88,321
                                     ----------------------------------------------------------------------
   Total revenues                             -        4,764,625      240,998                     5,005,623
 
   Operating costs and expenses:
   Cost of sales--retail store
    sales                                     -             -         149,775                       149,775
   Cost of sales--wholesale
    merchandise sales                         -        3,276,953         -                        3,276,953
   Retail store operating expenses            -             -          69,261                        69,261
   General and administrative             2,335          811,873         -         $ 280,500 (2)  1,094,708
   Depreciation and amortization              -           13,238         -           180,000 (3)    193,238
                                     ----------------------------------------------------------------------
                                          2,335        4,102,064      219,036        460,500      4,783,935
                                     ----------------------------------------------------------------------
   Operating income (loss)               (2,335)         662,561       21,962       (460,500)       221,688
   Other income                           2,037           57,831       27,612        (39,209)(1)     48,271
</TABLE>

                                     F-35
<PAGE>
 
<TABLE> 
<CAPTION> 
<S>                                        <C>           <C>           <C>          <C>             <C> 
                                     ----------------------------------------------------------------------
   Income (loss) before income
    taxes                                  (298)         720,392       49,574       (499,709)       269,959

   Pro forma provision for income
    taxes                                     -             -            -            94,000 (4)     94,000
                                     ----------------------------------------------------------------------
   Pro forma net income (loss)       $     (298)     $   720,392    $  49,574      $(593,709)    $  175,959
                                     ----------------------------------------------------------------------
                                     ----------------------------------------------------------------------

   Pro forma net income per share                                                                      $.10
                                                                                                 ----------
                                                                                                 ----------

   Shares used in computation                                                                     1,780,000
                                                                                                 ----------
                                                                                                 ----------
</TABLE> 

                                     F-36
<PAGE>
 
                             CD WAREHOUSE, INC.
              PRO FORMA COMBINED CONDENSED STATEMENT OF OPERATIONS
                       Year Ended December 31, 1996
                               (unaudited)


                          Pro Forma Adjustments:

(1)  Eliminate partnership interests retained by CDIL          $  39,209
                                                               ---------
                                                               ---------

(2)  Adjust executive compensation as a result of employment
      arrangements with new officers of the Company            $ 280,500
                                                               ---------
                                                               ---------

(3)  Amortization of estimated goodwill on purchase
      transactions over twenty-year period                     $ 180,000
                                                               ---------
                                                               ---------

(4)  Provide for income taxes at statutory rate                $  94,000
                                                               ---------
                                                               ---------

                                     F-37