<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C.  20549

                                --------------

                                   FORM 10-Q

[X]            QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934
                 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1997

                                      OR


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

                        Commission file number 0-24936


                                7TH LEVEL, INC.
            (Exact name of registrant as specified in its charter)

            DELAWARE                             75-2480669
     (State of incorporation)       (I.R.S. Employer Identification No.)

    1110 EAST COLLINS BOULEVARD
           SUITE 122
        RICHARDSON, TEXAS                          75081
(Address of principal executive offices)         (Zip Code)

      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (972) 498-8100

     Registrant (1) has filed all reports required to be filed by Section 13 or
15(D) of the Securities Exchange Act of 1934 during the preceding 12 months and
(2) has been subject to such filing requirements for the past 90 days.

                           Yes     X         No  
                                 -----           -----

     Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.

         COMMON STOCK, $0.01 PAR VALUE                 13,737,196
            (Title of Each Class)           (Number of Shares Outstanding at
                                                     August 6, 1997)
<PAGE>
 
                                7TH LEVEL, INC.

                                   Form 10-Q
                 For the Quarterly Period Ended June 30, 1997

                                     Index
 
PART I           FINANCIAL INFORMATION                         Page No.
                                                               --------

Item 1           Condensed Consolidated Balance Sheets at
                 June 30, 1997 and December 31, 1996               3
 
                 Condensed Consolidated Statements of
                 Operations for the Three and Six Months           4
                 Ended June 30, 1997 and 1996
 
                 Condensed Consolidated Statements of
                 Cash Flows for the Six Months Ended June          5
                 30, 1997 and 1996
 
                 Notes to Condensed Consolidated                   6
                 Financial Statements
 
Item 2           Management's Discussion and Analysis of
                 Financial Condition and  Results of               7
                 Operations
 
PART II          OTHER INFORMATION
 
Item 2           Changes in Securities                            11
 
Item 6           Exhibits and Reports on Form 8-K                 11
 
                 SIGNATURE                                        12
 
<PAGE>
Part I - FINANCIAL INFORMATION
Item I. Condensed Consolidated Financial Statements


                                7TH LEVEL, INC.
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                  (unaudited)

<TABLE>
<CAPTION>

                                                             June 30, 1997 December 31, 1996
                                                             ------------- -----------------
<S>                                                          <C>           <C>

                                     ASSETS

Cash and cash equivalents                                    $  5,483,488    $ 10,798,372
Short-term investments                                          1,499,627       4,485,470
Accounts receivable, net                                        1,295,546       6,130,903
Inventories                                                       213,266         571,545
Building for sale                                                       -       5,117,222
Other current assets                                            1,759,933       1,776,446
                                                             ------------    ------------
                Total current assets                           10,251,860      28,879,958
Fixed assets, net                                               6,833,773       7,839,278
Intangible assets, net                                            759,743       1,130,095
Other assets                                                      803,520       1,083,603
                                                             ------------    ------------
                Total assets                                 $ 18,648,896    $ 38,932,934
                                                             ============    ============

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Accounts payable                                             $  1,289,572    $  2,190,290
Accrued expenses and other current liabilities                  5,117,178       5,304,595
Current portion of notes payable                                        -       5,633,675
                                                             ------------    ------------
                Total current liabilities                       6,406,750      13,128,560
Notes payable                                                      94,550          94,626
Notes payable to related parties                                  445,956         581,098
Other                                                             455,359         476,263
                                                             ------------    ------------
                Total liabilities                               7,402,615      14,280,547
Commitments and contingencies
Stockholders' equity:
        Common stock                                              137,252         135,795
        Additional capital                                     70,561,820      70,347,110
        Accumulated deficit                                   (59,467,427)    (45,875,900)
        Cumulative translation adjustment                          13,832          51,193
        Unrealized gain (loss) on investments                         804          (5,811)
                                                             ------------    ------------
                Total stockholders' equity                     11,246,281      24,652,387
                                                             ------------    ------------
                Total liabilities and stockholders' equity   $ 18,648,896    $ 38,932,934
                                                             ============    ============
</TABLE>

                            See accompanying notes.

                                       3

<PAGE>
                                7TH LEVEL, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (Unaudited)

<TABLE>
<CAPTION>
                                        Three Months Ended     Three Months Ended       Six Months Ended        Six Months Ended
                                          June 30, 1997           June 30, 1996           June 30, 1997           June 30, 1996
                                          -------------           -------------           -------------           ------------- 
<S>                                        <C>                 <C>                      <C>                     <C>
Net revenues                               $    963,736            $  5,025,883            $  5,161,572            $  9,398,971
Cost of revenues                              1,037,013               2,290,874               3,703,148               3,327,636
                                           ------------            ------------            ------------            ------------ 
       Gross profit (loss)                      (73,277)              2,735,009               1,458,424               6,071,335
                                           ------------            ------------            ------------            ------------
                                                                                                        
Operating expenses:                                                                                     
       Research and product development       4,033,503               5,054,251               8,621,283               9,996,382
       Sales and marketing                    1,821,248               3,303,166               3,724,593               5,938,463
       General and administrative             1,365,651               1,256,374               2,939,426               2,339,052
       Amortization of intangible assets         27,160                  26,031                  54,319                  55,708
                                           ------------            ------------            ------------            ------------
             Total operating expenses         7,247,562               9,639,822              15,339,621              18,329,605
                                           ------------            ------------            ------------            ------------
             Operating loss                  (7,320,839)             (6,904,813)            (13,881,197)            (12,258,270)
Interest and other, net                         181,681                 340,821                 280,793                 772,310
                                           ------------            ------------            ------------            ------------
             Net loss                      $ (7,139,158)           $ (6,563,992)           $(13,600,404)           $(11,485,960)
                                           ============            ============            ============            ============
                                                                                                        
Loss per common share                      $      (0.52)           $      (0.49)           $      (1.00)           $      (0.86)
                                           ============            ============            ============            ============
                                                                                                        
Weighted average common stock and                                                                       
       common equivalent shares              13,628,742              13,472,722              13,612,820              13,344,687
                                           ============            ============            ============            ============

</TABLE>

                            See accompanying notes.

                                       4
<PAGE>
                                7TH LEVEL, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                                              Six Months Ended       Six Months Ended
                                                                                June 30, 1997          June 30, 1996
                                                                                -------------          ------------- 
<S>                                                                           <C>                    <C>
Cash flows from operating activities:
      Net loss                                                                  $(13,600,404)          $(11,485,960)
      Adjustments to reconcile net loss to net cash used in                                    
           operating activities:                                                               
                Depreciation and amortization                                      1,791,983              1,051,567
                Gain on sale of building                                             (94,802)                     -
                Gain on early retirement of debt                                     (10,142)                     -
                Change in operating assets and liabilities                         3,991,113               (536,313)
                                                                                ------------           ------------ 
                          Net cash used in operating activities                   (7,922,252)           (10,970,706)
                                                                                ------------           ------------
                                                                                               
Cash flows from investing activities:                                                          
      Acquisitions, net of cash acquired                                                   -                  6,323
      Capital expenditures                                                          (427,910)            (5,443,136)
      Proceeds from sale of building                                               5,594,010                      -
      Other investments                                                                    -               (400,000)
      Sale (purchase) of short-term investments                                    2,992,458             (2,591,250)
                                                                                ------------           ------------
                          Net cash provided by (used in) investing activities      8,158,558             (8,428,063)
                                                                                ------------           ------------
                                                                                               
Cash flows from financing activities:                                                          
      Issuance of Common Stock under stock option                                              
                and stock purchase plans                                             216,167                497,890
      Repayment of long-term obligations                                          (5,750,000)                     -
                                                                                ------------           ------------
                         Net cash provided by (used in ) financing activities     (5,533,833)               497,890
                                                                                ------------           ------------
                                                                                               
                         Effect of exchange rate changes on cash                     (17,357)                (9,320)
                                                                                ------------           ------------
                         Net decrease in cash                                     (5,314,884)           (18,910,199)
Cash and cash equivalents, beginning of period                                    10,798,372             29,940,217
                                                                                ------------           ------------
Cash and cash equivalents, end of period                                        $  5,483,488           $ 11,030,018
                                                                                ============           ============
</TABLE>

                            See accompanying notes.

                                       5
<PAGE>
 
                                7TH LEVEL, INC.

             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

1.  Basis of Presentation

          The condensed consolidated financial statements of 7th Level, Inc.
(the "Company") are unaudited and reflect all adjustments, consisting of normal
recurring adjustments, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods.  These condensed
consolidated financial statements should be read in conjunction with the
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 1996.  The results of operations
for the three and six months ended June 30, 1997 are not necessarily indicative
of the results for the entire year ending December 31, 1997.

2.  Loss per Share

          Primary loss per share is computed by dividing the net loss by the
weighted average common shares outstanding.  Warrants and options to purchase
common stock have been excluded from the loss per share computation because the
effect would be anti-dilutive.  Fully diluted loss per share has not been
presented because the result of the computation would be anti-dilutive.

                                       6
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

          The following information should be read in conjunction with the
financial statements and the notes thereto and in conjunction with Management's
Discussion and Analysis of Financial Condition and Results of Operations in the
Company's Annual Report on Form 10-K for the year ended December 31, 1996.  This
analysis is provided pursuant to applicable Securities and Exchange Commission
regulations and is not intended to serve as a basis for projections of future
events.

OVERVIEW

          On March 10, 1997, Donald Schupak was named the Chairman of 7th Level
Board of Directors and Robert A. Ezrin, the Company's co-founder and President,
assumed the duties of Chief Executive Officer. The new management's intention is
to leverage the Company's core technology and to position the Company to benefit
from the educational and entertainment assets and technologies it has developed.
The Company is also pursuing opportunities to benefit from the utilization of
its technology and integrated studio capacity in conjunction with other content
owners, developers and marketers, and is seeking to leverage its assets and
technology through key strategic relationships.(1) The Company's near-term
business priorities include the completion of a number of interactive software
titles for use on Multimedia PCs. While the Company has developed and produced
15 titles over the last three years, including two new titles in the quarter
ended March 31, 1997, the Company released no new titles in the quarter ended
June 30, 1997. Revenue for the quarter was correspondingly low and the Company
continues to use cash and operate at a significant loss. (See "Liquidity and
Capital Resources".)

          The Company has made substantial expenditures to develop its business
and technologies. It also enacted a number of cost saving measures in the second
half of 1996 and has continued to reduce expenditures in the first half of 1997.
By implementing optimized production processes and technologies the Company has
been able to reduce production staffing. In addition, the new management
continues to review, evaluate and revise the Company's operations and
priorities.(1) The Company expects that its operating results will fluctuate as
a result of a variety of factors, including changes in the composition of the
Company's revenues, the timing and costs of new titles released by the Company
and the seasonal nature of the market for consumer software with the peak demand
in the fourth calendar quarter or holiday selling season.(1)


RESULTS OF OPERATIONS

Three Month Periods Ended June 30, 1997 and June 30, 1996

     In the three months ended June, 1997, 7th Level net revenues decreased to
$963,736, which is significantly lower than the $5,025,883 achieved in the three
months ended June 30, 1996. The Company launched no new titles and experienced
sluggish sales on titles in the back catalog during the three months ended June
30, 1997. By contrast, Monty Python's Quest for the Holy Grail, which has been
one of the Company's most successful titles, was launched in the three months
ended June 30, 1996. Gross revenues for the second quarter of 1997 were reduced
approximately eight hundred thousand dollars for returns allowances and price
reductions on inventory already in the channel. The Company continued pricing
actions into the second quarter of 1997 to stimulate sales through the
distribution channel. The Company's returns allowance is higher than previously
experienced as many of the titles in the back catalog are not achieving sales
expectations at the retail level and risk losing shelf space. In the second
three months of 1997, approximately 45% of net revenues related to products
sales and the remaining 55% was from licensing, OEM and development contracts.
The composition of net revenues was comparable in the second three months of
1996, which included approximately 46% of revenues from product sales and 54%
from licensing, OEM and development contracts.

     Cost of revenues for the quarter ended June 30, 1997 was $1,037,013 or 108%
of net revenue, including product development, manufacturing, and royalty and
licensing costs of $481,955, $338,464 

                                       7
<PAGE>
 
and $216,593, respectively. For the quarter ended June 30, 1996, cost of
revenues was $2,290,875 or 46% of net revenues. The significant increase in cost
of revenues in the 1997 period as a percentage of net revenues is due to
numerous factors including the returns and price protection adjustments noted
above as well as asset valuation reductions, primarily inventory and prepaid
royalties, along with lower margins associated with development revenue. The
Company expects fluctuations in gross margin in the future as changes occur in
the composition of the revenues and the associated cost of revenues.(1)

     Research and product development expenses were $4,033,503 and $5,054,251
for the three months ended June 30, 1997 and 1996, respectively.  Research and
product development costs decreased in the 1997 period as the Company continued
to reduce headcount and related expenditures.  Results from the 1996 period
include spending for approximately ten titles in active production, compared to
about five titles in the 1997 period.  In the three months ended June 30, 1997
and 1996, research and product development expenses include $1,829,043  and
$2,903,165 for production costs, $735,601 and $1,205,783 for software research
and development, and $1,468,859 and $945,303, respectively, for expenses of the
companies acquired in 1995 and 1996 to provide expertise in the development of
3D technology and graphics design and to provide the capabilities needed to
expand into the Asia Pacific market.

     Sales and marketing expenses were $1,821,248 and $3,303,166 for the quarter
ended June 30, 1997 and 1996, respectively.  Sales and marketing expenses
included $782,061 and $2,131,140 of expenses for advertising, marketing and
public relations and $1,039,187 and $1,172,026 of expenses related to internal
staffing for the three months ended June 30, 1997 and 1996, respectively.
Although internal staffing remained relatively comparable between these two
periods, advertising, marketing and public relations decreased by $1,349,079
primarily because the Company launched no new titles in the second quarter of
1997.

     General and administrative expenses for the three months ended June 30,
1997 were $1,365,651 compared with $1,256,374 for the three months ended June
30, 1996.

     Net interest income and other was $181,681 for the three months ended June
30, 1997 compared to $340,821 for the three months ended June 30, 1996.
Included in the amount for 1997 was approximately $95,000 for the gain
recognized from the sale of an office building, net of the interest capitalized
as a cost of financing the acquisition of land and office building construction.
The decrease in interest income was due to lower average cash balances and
higher debt outstanding in the second quarter of 1997 compared to 1996.


Six Month Periods Ended June 30, 1997 and June 30, 1996

          For the six months ended June 30, 1997, net revenues totaled
$5,161,572 compared to $9,398,971 for the six months ended June 30, 1996.  Net
revenues for the six months ended June 30, 1997 included price allowances of
$813,873 compared to $89,126 in the six months ended June 30, 1996.  Also, OEM
revenues in the first half of 1997 were lower than the first half of 1996 by
$1,631,984.  These two factors, coupled with decreased product sales and
development revenue resulted in an overall 45% decrease between the two periods.

          Cost of revenues during the six months ended June 30, 1997 was
$3,703,148 or 72% of net revenue.  For the six months ended June 30, 1996 cost
of revenues was $3,327,636 or 35% of net revenue. The gross margin was
negatively impacted by changes in the revenue mix for the six months ended June
30, 1997, through the inclusion of substantial returns and price protection
adjustments and development revenue, which has a higher cost of revenue than
product sales or OEM licensing revenue.

          Research and product development expenses were $8,621,284 for the six
months ended June 30, 1997 compared to $9,996,382 for the six months ended June
30, 1996.  Research and product development expenses decreased 14% over the same
period of the prior year.  Although the Company is 

                                       8
<PAGE>
 
focused on optimization of its production processes and technology, the Company
continues to experience higher costs than expected on several titles.

          Sales and marketing expenses were $3,724,593, or 72% of revenues, for
the six months ended June 30, 1997, compared to $5,938,463, or 63% of revenues,
for the six months ended June 30, 1996.  Internal staffing expenses decreased
approximately 20% as a result of consolidation of the Company's European sales
and marketing activities.  Costs for advertising, marketing and public relations
decreased by 48% in the first half of 1997 compared to the first half of 1996.

          General and administrative expenses were $2,939,426 for the six months
ended June 30, 1997, compared with $2,339,052 for the six months ended June 30,
1996.  Approximately $400,000 of the increase in the 1997 period was associated
with expenses related to employee resignations in the first quarter of 1997.

          While the Company has continued to reduce total operating expenses
over the last three quarters, the Company has maintained a high capacity in a
number of departments to retain a high degree of flexibility to pursue new
business opportunities. The Company plans to take actions to significantly
reduce this capacity and these expenses in the third quarter of 1997.

          Net interest income and other was $280,793 for the six months ended
June 30, 1997 compared to $772,310 recognized in the six months ended June 30,
1996. The decrease is primarily because of lower cash balances available for
investment along with higher average debt outstanding.


LIQUIDITY AND CAPITAL RESOURCES

          As noted above, in March 1997 there was a substantial change in the
Company's management. During the last fiscal quarter management has been re-
examining the Company's business and assets, and establishing a strategy to
benefit the Company and its shareholders. The Company has retained a financial
advisor to provide consulting services and assist the Company in evaluating its
business opportunities, resources and requirements. As a result of that
analysis, management is in the process of implementing a strategy with a view to
generating capital through the utilization of its technology assets by pursuing
strategic combinations, joint ventures and other potential arrangements with a
variety of potential partners. The Company is also seeking to realize value and
capital resources by capitalizing on its educational and entertainment assets
with a variety of marketing and other partners. Although discussions involving
these potential transactions continue to progress, there can be no assurance
that any of these arrangements will be consummated on terms acceptable to the
Company, if at all.

          Cash and short term investments decreased $8,300,727 during the first
half of the year to $6,983,115 at June 30, 1997. The decrease is primarily the
result of the net loss of $13,600,404 in the six months ended June 30, 1997
offset by the positive impact from the management of cash receipts and payments
as well as the non-cash depreciation and amortization expenses. In the quarter
ended June 30, 1997, the Company's cash balance decreased $4,044,741 and the
Company completed the sale of the office building and used the net proceeds to
repay the principal balance of $5,250,000 plus accrued interest on its line of
credit. The Company has significantly curtailed capital expenditures, with
disbursements of $148,654, net of the office building, in the first six months
of 1997 compared to $5,443,136 in the same period of 1996. Capital expenditures
for the balance of 1997 are anticipated to be significantly below 1996 levels
(1), however, the Company continues to use cash and operate at a loss.

          The Company is taking steps to reduce its cash usage from the current
rate of approximately $2.0 million per month(1). In the event that the Company
is unable to adequately reduce its usage rate and/or is unable to generate
capital from the strategic activities described above, current assets alone,
including a $7.0 million balance of cash and short-term securities, may be
insufficient to satisfy the Company's capital requirements for the next twelve
months. With the high level of collections in the second quarter and the
resulting low level of accounts receivable available to secure an asset based
credit line, the Company does not anticipate it will be able to secure an asset
based credit facility on terms acceptable to the Company. As articulated above,
the Company's main focus in addressing its liquidity needs is the pursuit of
various strategic transactions which are the subject of ongoing discussions.

                                       9
<PAGE>
 
RECENTLY ISSUED ACCOUNTING PRINCIPLES

          In February 1997, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS
No. 128").  SFAS No. 128 specifies the computation, presentation and disclosure
requirements for earnings per share ("EPS") for entities with publicly held
common stock or potential common stock.  SFAS No. 128 is effective for financial
statements issued for period ending after December 15, 1997 and earlier
application is not permitted.  Upon adoption, all prior period per-share
information must be restated.  The adoption of SFAS No. 128 is not expected to
affect the Company's previously reported loss per share amounts.

-----------------------------------------------
(1)  Certain statements contained herein including those indicated by (1) are
     forward looking statements that involve risks and uncertainties.
     Accordingly, no assurance can be given that the actual events and results
     will not be materially different than the anticipated results described in
     the forward looking statement.  There are a number of important factors
     that could cause actual results to differ materially from those expressed
     in any forward looking statements made by the Company.  These factors
     include the Company's ability to generate cash income in the third quarter
     of 1997, the success of the Company's cost reduction strategy, the ability
     to attract and retain strategic partners, the ability to leverage
     intangible assets in its technology, the ability to complete new projects
     at planned costs and on planned schedules and the market acceptance of the
     Company's products.  See the discussion of the Company's business and a
     description of the various factors that could materially affect the ability
     of the Company to achieve the anticipated results described in the forward
     looking statement which is included in Item 1. of the Company's Report on
     Form 10-K for the year ended December 31, 1996.

                                       10
<PAGE>
 
                                7TH LEVEL, INC.

                          Part II.  Other Information

Item 2.   Changes in Securities

               Donald Schupak, 7th Level Chairman of the Board has been granted
          additional options for 560,000 shares of Common Stock outside of the
          Non-Employee Directors' Stock Option Plan ("the Options").  The grant
          was issued on May 9, 1997, at prices and vesting as follows:
            186,666 shares at $2.44 per share vesting on May 9, 1997;
            186,667 shares at $3.38 per share vesting on September 10, 1997; and
            186,667 shares at $5.00 per share vesting on March 10, 1998.

               As determined by the Company's Board of Directors, at the
          appropriate time,  the Company shall register for issuance under the
          Securities Act of 1933, as amended (the "Act"), the shares of Common
          Stock acquired upon exercise of the Options, and to keep such
          registration effective thereafter throughout the period the Options
          are exercisable.  In the absence of such effective registration or an
          available exemption from registration under the Act, issuance of
          shares of Common Stock acquirable upon exercise of the Options will be
          delayed until registration of such shares is effective or an exemption
          from registration under the Act is available.  In the event exemption
          from registration under the Act is available upon exercise of the
          Options, the holder, if requested by the Company to do so, will
          execute and deliver to the Company in writing an agreement containing
          such provisions as the Company may require to assure compliance with
          applicable securities laws.

               On August 8, 1997, Zolfo Cooper, LLC was issued 40,000 shares of
          Common Stock in a private placement as payment in kind for partial
          compensation for their services as financial advisor to the Company.


Item 6.   Exhibits and Reports on Form 8-K

(a)       Exhibits - none

(b)       Reports on Form 8-K - none

                                       11
<PAGE>
 
                                7TH LEVEL, INC.

                                   Signature

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

                                   7TH LEVEL, INC.


 
Date: August 14, 1997              By:   /s/ David W. Craig
                                      ----------------------------------
                                         David W. Craig
                                         Chief Financial Officer
                                         (Principal Financial Officer and
                                         Principal Accounting Officer)

                                       12