##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549


_____________
FORM 10-Q


(Mark One)

CHECKBOX  Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934



For the quarterly period ended January 31, 2002 or


BOX  Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934

For the transition period from__________________________to_________________________________________________

Commission file number 0-17521

ZILA, INC.

---



|                                                                        |  |                                                
|----------------------------------------------------------------------- |  | -----------------------------------------------
|Delaware
(State or Other Jurisdiction of Incorporation or Organization) |  | 86-0619668
(I.R.S. Employer Identification No.)

|                                         |  |  |  |           
|---------------------------------------- |  |  |  | ----------
|5227 North 7th Street, Phoenix, Arizona  |  |  |  | 85014     
|                                        
|(Address of Principal Executive Offices) |  |  |  | (Zip Code)

Registrants Telephone Number, Including Area Code (602) 266-6700

Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report

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

APPLICABLE ONLY TO CORPORATE ISSUERS

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

At January 31, 2002, the number of shares of common stock outstanding was
45,666,160.



Exhibit Index 24
Total pages 25


1



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TABLE OF CONTENTS



|                              |                                                                                               |                                                      |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Financial Statements                                                                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Quantitative and Qualitative Disclosures about Market Risk                           
|Part II  Other Information  
|                              | ITEM 1.- LEGAL PROCEEDINGS                                                                   
|                              | ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS                                            
|                              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.                                 
|                              | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURES                   



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##### Table of Contents



TABLE OF CONTENTS

|         |  |                                                                                                                     |  |         
|-------- |  | ------------------------------------------------------------------------------------------------------------------- |  | --------
|         |  |                                                                                                                     |  | Page no.
|Part I.  |  | FINANCIAL INFORMATION                                                                                               |  |         
|        
|Item 1.  |  | Financial Statements (Unaudited)                                                                                    |  |         
|        
|         |  | Condensed consolidated balance sheets as of January
31, 2002 and July 31, 2001                                      |  | 3       
|        
|         |  | Condensed consolidated statements of operations for
the three months and six months ended January 31, 2002
and 2001 |  | 4       
|        
|         |  | Condensed consolidated statements of cash flows for
six months ended January 31, 2002 and 2001                      |  | 5       
|        
|         |  | Notes to condensed consolidated financial statements                                                                |  | 6-14    
|        
|Item 2.  |  | Managements discussion and analysis of financial condition
and results of operations                               |  | 15-22   
|        
|Item 3.  |  | Quantitative and qualitative disclosures about market risk                                                          |  | 22      
|        
|        
|Part II. |  | OTHER INFORMATION                                                                                                   |  |         
|        
|Item 1.  |  | Legal proceedings                                                                                                   |  | 23      
|        
|Item 2.  |  | Changes in Securities and use of proceeds                                                                           |  | 24      
|        
|Item 4.  |  | Submission of matters to a vote of Security Holders                                                                 |  | 24      
|        
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                                    |  | 24      
|        
|         |  | SIGNATURES                                                                                                          |  | 25      

2



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES










CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |               |            |            |            | 
|-------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------- | ----------------- | ---------- | ---------------- | ---------- | ------------- | ---------- | ---------- | ---------- | 
|                                             |                                                                                                                                         |                            |                           |                   |            | January 31, 2002 |            | July 31, 2001
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|ASSETS                                       |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|CURRENT ASSETS:                              |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             | Cash and cash equivalents                                                                                                               |                            | $                         | 431,124           |            |                  | $          | 1,263,935     |           
|                                             | Trade receivables  net                                                                                                                 |                            |                           | 6,906,428         |            |                  |            | 6,771,668     |           
|                                             | Inventories  net                                                                                                                       |                            |                           | 9,479,659         |            |                  |            | 11,101,897    |           
|                                             | Assets of business transferred under contractual arrangements                                                                           |                            |                           | 5,745,892         |            |                  |            | 7,877,217     |           
|                                             | Assets of discontinued operation                                                                                                        |                            |                           |                   |            |                  |            | 4,155,500     |           
|                                             | Prepaid expenses and other current assets                                                                                               |                            |                           | 3,059,912         |            |                  |            | 1,823,212     |           
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            | Total current assets      |                   |            | 25,623,015       |            |               |            | 32,993,429 |           
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|PROPERTY AND EQUIPMENT  net                 |                                                                                                                                         |                            | 9,210,000                 |                   |            |                  | 9,456,337  |              
|PURCHASED TECHNOLOGY RIGHTS  net            |                                                                                                                                         |                            | 4,946,315                 |                   |            |                  | 5,164,535  |              
|GOODWILL  net                               |                                                                                                                                         |                            | 11,989,468                |                   |            |                  | 12,383,291 |              
|TRADEMARKS AND OTHER INTANGIBLE ASSETS  net |                                                                                                                                         |                            | 15,424,388                |                   |            |                  | 12,721,567 |              
|OTHER ASSETS                                 |                                                                                                                                         |                            | 278,127                   |                   |            |                  | 3,837,970  |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|TOTAL                                        |                                                                                                                                         | $                          | 67,471,313                |                   |            | $                | 76,557,129 |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|LIABILITIES AND SHAREHOLDERS EQUITY         |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|CURRENT LIABILITIES:                         |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             | Accounts payable                                                                                                                        |                            | $                         | 3,292,614         |            |                  | $          | 2,809,203     |           
|                                             | Accrued liabilities                                                                                                                     |                            |                           | 3,447,992         |            |                  |            | 2,317,317     |           
|                                             | Short-term borrowings                                                                                                                   |                            |                           | 2,284,516         |            |                  |            | 6,160,947     |           
|                                             | Liabilities of business transferred                                                                                                     |                            |                           | 1,392,024         |            |                  |            | 2,991,175     |           
|                                             | Liabilities of discontinued operations                                                                                                  |                            |                           |                   |            |                  |            | 730,738       |           
|                                             | Current portion of long-term debt                                                                                                       |                            |                           | 469,826           |            |                  |            | 747,648       |           
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            | Total current liabilities |                   |            | 10,886,972       |            |               |            | 15,757,028 |           
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|LONG-TERM DEBT  net of current portion      |                                                                                                                                         |                            | 3,845,014                 |                   |            |                  | 4,079,496  |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           | Total liabilities |            |                  | 14,731,986 |               |            |            | 19,836,524 | 
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|COMMITMENTS AND CONTINGENCIES                |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|SHAREHOLDERS EQUITY:                        |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             | Preferred stock  Series B, $.001 par value  authorized 2,500,000 shares,
issued 100,000 shares                                        |                            |                           | 462,500           |            |                  |            | 462,500       |           
|                                             | Common stock, $.001 par value  authorized 65,000,000 shares, issued
45,666,160 shares (January 31, 2002 and 43,653,727 (July 31, 2001) |                            |                           | 45,666            |            |                  |            | 43,654        |           
|                                             | Capital in excess of par value                                                                                                          |                            |                           | 82,931,477        |            |                  |            | 79,930,094    |           
|                                             | Accumulated other comprehensive income                                                                                                  |                            |                           | 170,517           |            |                  |            | 150,976       |           
|                                             | Accumulated deficit                                                                                                                     |                            |                           | (30,335,713       | )          |                  |            | (23,331,499   | )         
|                                             | Common stock in treasury, at cost, 195,000 shares                                                                                       |                            |                           | (535,120          | )          |                  |            | (535,120      | )         
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         | Total shareholders equity |                           |                   | 52,739,327 |                  |            |               | 56,720,605 |           
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              
|TOTAL                                        |                                                                                                                                         | $                          | 67,471,313                |                   |            | $                | 76,557,129 |              
|                                             |                                                                                                                                         |                            |                           |                   |            |                  |            |              

See notes to condensed consolidated financial statements.

3



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |            |            |            |  
| | ------------------------------------------------------- | -------------------- | ----------------------------------- | --------------------------------------------------------------------------------------------------- | ---------- | ------------------------------ | ---------- | ---------------------------- | ---------- | --------- | ---------- | ---------- | ---------- | ---------- | ---------- | ---------- | ---------- | ---------- | ---------- | -
| |                                                         |                      |                                     |                                                                                                     |            | Three months ended January 31, |            | Six months ended January 31,
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                             
| |                                                         |                      |                                     |                                                                                                     |            | 2002                           |            | 2001                         |            | 2002      |            | 2001      
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | NET REVENUES                                            |                      | $                                   | 8,912,374                                                                                           |            |                                | $          | 8,388,664                    |            |           | $          | 17,903,593 |            |            | $          | 17,050,631 |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | OPERATING COSTS AND EXPENSES:                           |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      | Cost of products sold               |                                                                                                     |            | 3,200,546                      |            |                              |            | 2,636,459 |            |            |            | 6,312,481  |            |            |            | 5,226,116  |           
| |                                                         |                      | Selling, general and administrative |                                                                                                     |            | 6,821,007                      |            |                              |            | 5,730,652 |            |            |            | 12,097,211 |            |            |            | 10,515,934 |           
| |                                                         |                      | Research and development            |                                                                                                     |            | 789,050                        |            |                              |            | 1,108,676 |            |            |            | 1,356,739  |            |            |            | 1,472,543  |           
| |                                                         |                      | Impairment of building              |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |            | 310,000    |           
| |                                                         |                      | Depreciation and amortization       |                                                                                                     |            | 864,469                        |            |                              |            | 810,095   |            |            |            | 1,698,868  |            |            |            | 1,582,962  |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      | 11,675,072                          |                                                                                                     |            |                                | 10,285,882 |                              |            |           | 21,465,299 |            |            |            | 19,107,555 |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| |                                                         | LOSS FROM OPERATIONS |                                     |                                                                                                     | (2,762,698 | )                              |            |                              | (1,897,218 | )         |            |            | (3,561,706 | )          |            |            | (2,056,924 | )         
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | OTHER INCOME (EXPENSE):                                 |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      | Interest income                     |                                                                                                     |            | 16,111                         |            |                              |            | 76,207    |            |            |            | 37,951     |            |            |            | 116,611    |           
| |                                                         |                      | Interest expense                    |                                                                                                     |            | (88,996                        | )          |                              |            | (143,540  | )          |            |            | (279,249   | )          |            |            | (166,517   | )         
| |                                                         |                      | Other (expense) income              |                                                                                                     |            | (82,629                        | )          |                              |            | 9,776     |            |            |            | (88,847    | )          |            |            | (51,729    | )         
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| |                                                         |                      | (155,514                            | )                                                                                                   |            |                                | (57,557    | )                            |            |           | (330,145   | )          |            |            | (101,635   | )         
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | NET LOSS FROM CONTINUING
OPERATIONS BEFORE INCOME TAXES |                      |                                     | (2,918,212                                                                                          | )          |                                |            | (1,954,775                   | )          |           |            | (3,891,851 | )          |            |            | (2,158,559 | )         
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | INCOME TAX (EXPENSE) BENEFIT                            |                      |                                     | (3,179,343                                                                                          | )          |                                |            | 335,000                      |            |           |            | (3,189,824 | )          |            |            | 335,000    |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | NET LOSS FROM CONTINUING OPERATIONS                     |                      |                                     | (6,097,555                                                                                          | )          |                                |            | (1,619,775                   | )          |           |            | (7,081,675 | )          |            |            | (1,823,559 | )         
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | DISCONTINUED OPERATIONS:                                |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     | (Loss) income from operations of discontinued
Dental Supply segment                                 |            |                                | (370,018   | )                            |            |           | (6,656     | )          |            |            | (377,266   | )          |            |            | 34,573     |  
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| |                                                         |                      |                                     | Gain from disposal of full-service business of Dental
Supply segment, net of income tax of $329,149 |            |                                | 493,725    |                              |            |           |            |            |            |            | 493,725    |            |            |            |            |  
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | Total gain (loss) from discontinued operations          |                      |                                     | 123,707                                                                                             |            |                                |            | (6,656                       | )          |           |            | 116,459    |            |            |            | 34,573     |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | NET LOSS                                                |                      |                                     | (5,973,848                                                                                          | )          |                                |            | (1,626,431                   | )          |           |            | (6,965,216 | )          |            |            | (1,788,986 | )         
| | Preferred stock dividends                               |                      |                                     | 9,750                                                                                               |            |                                |            |                              |            |           |            | 19,500     |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | Net loss attributable to common shareholders            |                      | $                                   | (5,983,598                                                                                          | )          |                                | $          | (1,626,431                   | )          |           | $          | (6,984,716 | )          |            | $          | (1,788,986 | )         
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | BASIC AND DILUTED NET (LOSS) INCOME PER COMMON SHARE:   |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     | Loss from continuing operations                                                                     |            | $                              | (0.13      | )                            |            | $         | (0.04      | )          |            | $          | (0.16      | )          |            | $          | (0.04      | )
| |                                                         |                      |                                     | Gain from discontinued operations                                                                   |            |                                | 0.00       |                              |            |           |            |            |            |            | 0.00       |            |            |            |            |  
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     | NET LOSS                                                                                            |            | $                              | (0.13      | )                            |            | $         | (0.04      | )          |            | $          | (0.16      | )          |            | $          | (0.04      | )
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |           
| | WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING:          |                      |                                     |                                                                                                     |            |                                |            |                              |            |           |            |            |            |            |            |            |           
| |                                                         |                      |                                     | BASIC AND DILUTED                                                                                   |            |                                | 44,723,786 |                              |            |           | 43,423,899 |            |            |            | 44,094,713 |            |            |            | 43,388,570 |  

See notes to consolidated financial statements.

4



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##### Table of Contents



ZILA, INC. AND SUBSIDIARIES




CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |            |           |            |            |  
|------------------------------------------------------------------------ | --------------------------------------------------------------------------- | -------------------------------------------- | ---------------------------------------- | --------------------------------------------------- | --------- | ---------------------------- | ---------- | ---------- | --------- | ---------- | ---------- | -
|                                                                         |                                                                             |                                              |                                          |                                                     |           | Six months ended January 31,
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                             
|                                                                         |                                                                             |                                              |                                          |                                                     |           | 2002                         |            | 2001      
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|OPERATING ACTIVITIES:                                                    |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         | Net loss                                                                    |                                              | $                                        | (6,965,216                                          | )         |                              | $          | (1,788,986 | )        
|                                                                         | Adjustments to reconcile net loss to net cash used in operating activities: |                                              |                                          |                                                     |           |                              |            |            |          
|                                                                         |                                                                             | Depreciation and amortization                |                                          |                                                     | 1,698,868 |                              |            |            | 1,582,962 |           
|                                                                         |                                                                             | Gain from discontinued operations            |                                          |                                                     | (116,459  | )                            |            |            | (34,573   | )         
|                                                                         |                                                                             | Impairment of asset                          |                                          |                                                     |          |                              |            |            | 310,000   |           
|                                                                         |                                                                             | Deferred income taxes and other              |                                          |                                                     | 3,579,384 |                              |            |            | (309,089  | )         
|                                                                         |                                                                             | Change in assets and liabilities:            |                                          |                                                     |           |                              |            |            |           |           
|                                                                         |                                                                             |                                              | Receivables  net                        |                                                     |           | (134,760                     | )          |            |           | (804,399   | )         
|                                                                         |                                                                             |                                              | Inventories                              |                                                     |           | 1,622,238                    |            |            |           | (3,900,518 | )         
|                                                                         |                                                                             |                                              | Prepaid expenses and other assets        |                                                     |           | (864,355                     | )          |            |           | (491,365   | )         
|                                                                         |                                                                             |                                              | Accounts payable and accrued liabilities |                                                     |           | 1,575,088                    |            |            |           | 33,833     |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          | Net cash provided by (used in) operating activities |           |                              | 394,788    |            |           |            | (5,402,135 | )
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|INVESTING ACTIVITIES:                                                    |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         | Purchases of property and equipment                                         |                                              |                                          | (283,598                                            | )         |                              |            | (2,210,864 | )        
|                                                                         | Transfers from discontinued operations                                      |                                              |                                          | (1,678,058                                          | )         |                              |            | (171,691   | )        
|                                                                         | Net proceeds from disposition of discontinued operations                    |                                              |                                          | 5,751,453                                           |           |                              |            |            |          
|                                                                         | Purchases of intangible assets                                              |                                              |                                          | (654,024                                            | )         |                              |            | (449,268   | )        
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          | Net cash provided by (used in) investing activities |           |                              | 3,135,773  |            |           |            | (2,831,823 | )
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|FINANCING ACTIVITIES:                                                    |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         | Net (repayments) proceeds from short-term borrowings                        |                                              |                                          | (3,876,431                                          | )         |                              |            | 1,868,279  |          
|                                                                         | Net proceeds from issuance of common stock                                  |                                              |                                          | 25,363                                              |           |                              |            | 452,609    |          
|                                                                         | Acquisition of treasury stock                                               |                                              |                                          |                                                     |           |                              |            | (125,370   | )        
|                                                                         | Cash released by trustee                                                    |                                              |                                          |                                                     |           |                              |            | 1,550,719  |          
|                                                                         | Principal payments on long-term debt                                        |                                              |                                          | (512,304                                            | )         |                              |            | (246,730   | )        
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          | Net cash (used in) provided by financing activities |           |                              | (4,363,372 | )          |           |            | 3,499,507  |  
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|NET DECREASE IN CASH AND CASH EQUIVALENTS                                |                                                                             |                                              | (832,811                                 | )                                                   |           |                              | (4,734,451 | )         
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                           |                                                                             |                                              | 1,263,935                                |                                                     |           |                              | 5,192,251  |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                 |                                                                             | $                                            | 431,124                                  |                                                     |           | $                            | 457,800    |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|CASH PAID FOR INTEREST                                                   |                                                                             | $                                            | 222,484                                  |                                                     |           | $                            | 144,241    |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|CASH PAID FOR INCOME TAXES                                               |                                                                             | $                                            | 18,481                                   |                                                     |           | $                            | 89,686     |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING AND
FINANCING ACTIVITIES: |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           
|                                                                         |                                                                             | Issuance of common stock related to ViziLite |                                          | $                                                   | 2,978,032 |                              |            |            |           |           
|                                                                         |                                                                             |                                              |                                          |                                                     |           |                              |            |           

5



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##### Table of Contents






ZILA, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)



|1. | BASIS OF PRESENTATION
|-- | ---------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The condensed consolidated financial statements include the accounts of
Zila, Inc. and its wholly-owned subsidiaries, Zila Pharmaceuticals, Inc.,
Zila International, Inc., Zila, Ltd., Bio-Dental Technologies Corporation
(Bio-Dental) which does business under the name Zila Dental Supply
(ZDS), Zila Technologies, Inc., Zila Swab Technologies, Inc. dba
Innovative Swab Technologies (IST) and Oxycal Laboratories, Inc.
(Oxycal). This information should be read in conjunction with the
financial statements set forth in the Zila, Inc. Annual Report to
shareholders for the fiscal year ended July 31, 2001. All significant
intercompany balances and transactions are eliminated in consolidation.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In November 2001, the Company decided to sell the operations of the ZDS
business. These operations were sold during the second fiscal quarter
of 2002. The financial statements have been prepared to reflect our
historical financial position and results of operations and cash flows as
adjusted for the reclassification of the ZDS business as discontinued
operations. The historical results of the operations of the ZDS business
up to November 2001 and the gain recognized on the components of the sale
that have been transacted to date are reported as discontinued operations
in the accompanying consolidated financial statements.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In the opinion of management of Zila, Inc. and its subsidiaries
(collectively referred to herein as Zila or the Company), all
adjustments, consisting of normal recurring accruals, considered necessary
for a fair presentation have been included in the condensed consolidated
financial statements. The results of operations for the interim period
are not necessarily indicative of the results that may be expected for the
entire year. The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities, disclosure of contingent
assets and liabilities at the date of the financial statements and the
reported amounts of revenue and expenses during the reporting period.
Actual results could differ from those estimates. Significant estimates
include estimated cash flows used to measure long-lived assets for
impairment and the estimated net realizable value of inventories and
deferred tax assets.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The cash flows used to measure long-lived assets related to the OraTest®
product are dependent upon obtaining Food and Drug Administration (the
FDA) approval and generating sufficient revenues from sales of the
OraTest® product. The rigorous clinical testing and an extensive
regulatory approval process mandated by the FDA and equivalent foreign
authorities before the Company can market any new drug can take a number
of years and require the expenditure of substantial resources. The Company
will require additional financing to support these activities. Obtaining
such approvals and completing such testing is a costly and time-consuming
process, and approval may not be ultimately obtained. The length of the
FDA review period varies considerably, as does the amount of clinical data
required to demonstrate the safety and efficacy of a specific product. The
Company has net intangible assets related to the OraTest® product as of
January 31, 2002 of $6.1 million.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Nutraceuticals Group entered the saw palmetto business with its
Palmettx line of products during the prior fiscal year. In order to take
advantage of bulk purchase discounts and to establish a reputation as a
reliable supplier, the Company purchased a large amount of inventory in
fiscal year 2001, of which $4.5 million remains as of January 31, 2002.
The ultimate probable future economic benefit associated with such
inventory is contingent on the Companys ability to

6



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| |                                                                                                     
| | ----------------------------------------------------------------------------------------------------
| | sell its line of saw palmetto products for a price greater than the
carrying value of the inventory.



| |                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The measurement of long-lived assets related to the Peridex® product is
dependent on the Companys ability to achieve its forecast of estimated
cash flows. The Company currently has net intangible assets related to
the Peridex® product as of January 31, 2002, of $7.7 million.



|2. | ACQUISITIONS
|-- | ------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In February 2001, the Company acquired the patent rights and the Antioch,
Illinois manufacturing operations for swab products from National
Healthcare Manufacturing Corporation, headquartered in Winnipeg, Canada.
Intellectual property, inventory, plus molding, labeling, filling and
sealing equipment were included in the acquisition. The business unit is
known as Innovative Swab Technologies and is combined in the Professional
Products segment. Zila paid approximately $2.4 million in a combination of
cash and preferred stock for the unit (See Note 10).



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On December 5, 2001, the Company acquired the world marketing rights
(excluding the Pacific Rim) for the ViziLite chemiluminescent light
technology from Trylon Corporation of Torrance, CA. Under the
transaction, the Company issued 1,625,000 of restricted shares of common
stock and placed an additional 375,000 shares of common stock into escrow.
Of the 1,625,000 restricted shares, 750,000 shares are restricted within
the meaning of Rule 144 under the Securities Act of 1933, as amended, and
may be eligible for sale subject to the holding period and other
requirements of that Rule, and the contractual restrictions on the remaining
875,000 shares will be removed at the earlier of 10 years following the
closing date or the achievement of certain future sales and government
approval milestones. Management has estimated the fair value of the
restricted 875,000 shares to be $1.1 million, which is reflected as an
addition to the value of the license acquired of $753,000 and a prepaid
research & development fee of $372,000. The Company will record an
adjustment to the fair value at the date the milestones are achieved. The
release of the 375,000 shares in escrow is contingent upon Trylon
obtaining regulatory approval of a product currently under development.
Due to the contingent nature of the approval process, the Company will not
record the research and development costs associated with these shares
until approval is obtained.



| |                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In addition, the Company entered into a license agreement with Trylon
related to the chemiluminescent light technology that requires the Company
to pay a royalty on sales of the ViziLite product of 10 percent in the
first five years, and five percent in the next five years.



|3. | DISCONTINUED OPERATIONS
|-- | -----------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In November 2001, the Company made the decision to dispose of its Zila
Dental Supply reporting segment. In November and December 2001, the
Company sold substantially all of the assets and certain liabilities of
the ZDS segment in two separate transactions. ZDSs full-service assets
were sold on November 5, 2001 to Henry Schein, Inc. of Melville, NY
(Nasdaq: HSIC) for approximately $5.8 million in cash. The Company
realized a gain from the disposal of the full service assets of
approximately $494,000, net of a current tax expense of approximately
$329,000. Proceeds from the sale were used to repay borrowings
outstanding under the

7



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##### Table of Contents





| |                                                              
| | -------------------------------------------------------------
| | revolving line of credit with Congress Financial Corporation.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The ZDS mail order operations (assets and liabilities) were sold on
December 4, 2001 to PracticeWares, Inc. of Sacramento, CA for
approximately $8.0 million in one short and two long term notes.
Approximately $5.7 million of the $8.0 million purchase price (net of post
closing adjustments) was due and payable January 11, 2002. The Company
extended the maturity date of the short-term note, upon payment of accrued
and prepaid interest, to February 15, 2002, and further extended the note
to March 1, 2002, with interest prepaid through the new maturity date.
The note has not been paid and is currently in default. Zila has various remedies including the
right to effect reconveyance to the Company. As a result of
PracticeWares failure to pay the short term notes, the transaction to
sell the mail order business no longer qualifies as a sale for accounting
purposes and the assets and liabilities of that operation have been
classified as current and shown as assets and liabilities of business
transferred under contractual arrangements. Operating results of the
operation will continue to be reflected in the income statement as
income
(loss) from operation of the discontinued Dental Supply Segment.
For current
and future quarters for which the business transferred has net income, such net income
may be recognized by the Company to the extent of any cumulative quarterly
losses within the same fiscal year. Similarly, quarterly losses of the
business need not be recognized by the Company except to the extent that
they exceed any cumulative quarterly net income within the same fiscal
year.                                                     
|
| | In March 2002, Zila and PracticeWares agreed, in principle, to restructure the
terms relating to the sale. Under the restructured terms, PracticeWares will
issue Zila a new, secured $8.54 million convertible note, bearing interest at
10 percent per year. Approximately 30 percent of the note is due and payable
in May 2002. That payment to Zila is expected to be financed by an
institutional lending source and will be subject to their approval. The
balance of the note, subject to certain post-closing adjustments, will be due
within five years on an amortization schedule negotiated by the parties. Zila
will receive, as part of the consideration, a 19.9 percent equity interest in
PracticeWares. PracticeWares shareholders will pledge their shares as
security for the note, and guarantees for a portion of the note will be provided by
PracticeWorks, Inc. (AMEX: PRW), and Greg Jones, President of PracticeWares. As part of the transaction,
PracticeWorks, Inc. (a dental practice management software systems provider)
and PracticeWares will enter into a 20-year e-commerce agreement under which
PracticeWares will be able to offer products and services to the PracticeWorks
dental subscriber base. In connection with the e-commerce agreement,
PracticeWorks, Inc. will have an option to purchase all of the PracticeWares
capital stock from its shareholders for the first five years of the e-commerce
agreement at a price equal to the greater of an appraised value or a minimum
value determined by the parties at closing. The e-commerce agreement and the
guarantee from PracticeWorks, Inc. are subject to approval of the PracticeWorks
board of directors.



| |                                                                                                                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The accompanying financial statements have been restated to conform to
discontinued operations treatment for all historical periods presented.
The following table shows the components of the discontinued operations as
of January 31, 2002 and July 31, 2001. Also included are the assets and
liabilities of the business transferred under contractual arrangements as
of January 31, 2002:

|                                                                |  |                  |           |               |  |   |            | 
|--------------------------------------------------------------- |  | ---------------- | --------- | ------------- |  | - | ---------- | 
|                                                                |  | January 31, 2002 |           | July 31, 2001
|                                                                |  |                  |           |              
|Current assets                                                  |  | $                | 5,044,940 |               |  | $ | 11,108,838 | 
|Property
and equipment  net                                    |  |                  | 196,264   |               |  |   | 386,766    | 
|Other assets                                                    |  |                  | 504,688   |               |  |   | 537,113    | 
|                                                                |  |                  |           |               |  |   |            | 
|Assets
of business transferred and discontinued operations      |  | $                | 5,745,892 |               |  | $ | 12,032,717 | 
|                                                                |  |                  |           |               |  |   |            | 
|                                                                |  |                  |           |               |  |   |            | 
|Current liabilities                                             |  |                  | 1,329,376 |               |  |   | 3,648,138  | 
|Long-term debt                                                  |  |                  | 62,648    |               |  |   | 73,775     | 
|                                                                |  |                  |           |               |  |   |            | 
|Liabilities
of business transferred and discontinued operations |  | $                | 1,392,024 |               |  | $ | 3,721,913  | 
|                                                                |  |                  |           |               |  |   |            | 
|                                                                |  |                  |           |               |  |   |            | 
|                                                                |  |                  |           |               |  |   |            | 
|Net
assets of business transferred and discontinued operations  |  | $                | 4,353,868 |               |  | $ | 8,310,804  | 
|                                                                |  |                  |           |               |  |   |            | 



| |                                                                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Sales for ZDS for the three and six month period ended January 31, 2002
thru the dates of disposition were $5,362,197 and $16,075,229. Sales for
the corresponding periods in 2001 were $10,168,697 and $20,342,965.

8



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##### Table of Contents





|4. | NET (LOSS) INCOME PER SHARE
|-- | ---------------------------



| |                                                                                                               
| | --------------------------------------------------------------------------------------------------------------
| | The following is a reconciliation of the numerator and denominator of
basic and diluted loss per common share:

|                                                   |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |            |  
|-------------------------------------------------- | ----------------- | - | -------------------------- | ---------- | ------------------------ | - | ---------- | ---------- | ---- | - | ---------- | ---------- | - | - | ---------- | ---------- | -
|                                                   |                   |   | For the three months ended |            | For the six months ended
|                                                   |                   |   | January 31,                |            | January 31,             
|                                                   |                   |   | 2002                       |            | 2001                     |   | 2002       |            | 2001
|                                                   |                   |  
|                                                   |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |           
|Net loss from continuing
operations                |                   | $ | (6,097,555                 | )          |                          | $ | (1,619,775 | )          |      | $ | (7,081,675 | )          |   | $ | (1,823,559 | )         
|Income (loss) from
discontinued operations         |                   |   | 123,707                    |            |                          |   | (6,656     | )          |      |   | 116,459    |            |   |   | 34,573     |           
|                                                   |                   |  
|Net loss                                           |                   |   | (5,973,848                 | )          |                          |   | (1,626,431 | )          |      |   | (6,965,216 | )          |   |   | (1,788,986 | )         
|Preferred stock dividends                          |                   |   | 9,750                      |            |                          |   |            |            |      |   | 19,500     |            |   |   |            |           
|                                                   |                   |  
|Net loss attributable to
common shareholders       |                   | $ | (5,983,598                 | )          |                          | $ | (1,626,431 | )          |      | $ | (6,984,716 | )          |   | $ | (1,788,986 | )         
|                                                   |                   |  
|                                                   |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |           
|Average shares of common shares outstanding:       |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |           
|                                                   | Basic and diluted |   |                            | 44,723,786 |                          |   |            | 43,423,899 |      |   |            | 44,094,713 |   |   |            | 43,388,570 |  
|                                                   |                   |  
|                                                   |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |           
|Net loss per share from continuing operations:     |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |           
|                                                   | Basic and diluted |   | $                          | (0.14      | )                        |   | $          | (0.04      | )    |   | $          | (0.16      | ) |   | $          | (0.04      | )
|Net income per share from discontinued operations: |                   |   |                            |            |                          |   |            |            |      |   |            |            |   |   |            |           
|                                                   | Basic and diluted |   | $                          | 0.00       |                          |   | $          | 0.00       |      |   | $          | 0.00       |   |   | $          | 0.00       |  



| |                                                                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Since a loss from continuing operations was incurred for the quarters and
six months ended January 31, 2001 and 2002, convertible preferred stock,
options and warrants to purchase shares of common stock that would
otherwise qualify as common stock equivalents were not included in the
computation of diluted net income per share because their effect would be
antidilutive.



|5. | INVENTORIES
|-- | -----------

Inventories consist of the following:

|                   |  |                  |           |               |  |   |            |  
|------------------ |  | ---------------- | --------- | ------------- |  | - | ---------- | -
|                   |  | January 31, 2002 |           | July 31, 2001
|                   |  |                  |           |              
|                   |  |                  |           |               |  |   |            |  
|Finished goods     |  | $                | 3,154,940 |               |  | $ | 4,128,119  |  
|Raw materials      |  |                  | 6,479,499 |               |  |   | 7,052,981  |  
|Inventory reserves |  |                  | (154,780  | )             |  |   | (79,203    | )
|                   |  |                  |           |               |  |   |            |  
|                   |  | $                | 9,479,659 |               |  | $ | 11,101,897 |  
|                   |  |                  |           |               |  |   |            |  



|6. | INCOME TAXES
|-- | ------------



| |                                                                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Deferred income taxes reflect the tax effect of temporary differences
between the amounts of assets and liabilities recognized for financial
reporting and tax purposes. At the end of each fiscal quarter, the
Company makes its best estimate of the effective tax rate expected to be

9



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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | applicable for the full fiscal year. The rate so determined is used in
providing for income taxes on a current year-to-date basis. In the three
months ended January 31, 2002, the Company recorded a tax benefit based on
the effective tax rate and offset the tax benefit with an increase in the
deferred tax asset valuation reserve. In addition, the Company recorded a
tax expense of $3.2 million primarily due to an increase in the deferred
tax asset valuation reserve related to managements evaluation of the
deferred tax asset. In the three months ended January 31, 2001, the
Company recorded a tax benefit of $335,000.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company has recorded total deferred tax assets of $5.0 million and a
valuation allowance against the deferred tax assets of $5.0 million. The
Company has offset a portion of its deferred tax assets with a valuation
allowance due to the Companys lack of earnings history. Management
believes the valuation allowance reduces deferred tax assets to an amount
that represents managements best estimate of the amount of such deferred
tax assets that more likely than not will be realized.



|7. | DEBT
|-- | ----



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On August 27, 2001, the Company and Congress Financial Corporation
(Congress) entered into a Loan and Security Agreement (the Agreement)
under which Congress provides a $12 million revolving line of credit (the
Line) to the Company at an interest rate equal to the prime rate plus
3/4 percent. A portion of the available funds from the Line were used to
pay off in full the line of credit and building loan due to Bank One,
Arizona, NA (Bank One) totaling approximately $6.4 million. The amount
of funds available to the Company under the Line is based upon a
percentage of the value of eligible receivables and inventory and was $5.6
million at January 31, 2002 of which, borrowings of $2.1 million were
outstanding.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The obligations under the Agreement are collateralized by various assets,
including, but not limited to, trade accounts receivable, inventories,
equipment and intangible assets of the Company and of certain of its
operating subsidiaries. Zila and all of its direct and indirect operating
subsidiaries guarantee the obligations under the Agreement. The Agreement
expires August 17, 2004; however, the Line is classified as current
because of certain provisions required by Congress. Under the Agreement,
the Company is required to comply with a financial covenant based on an
adjusted tangible net worth calculation. At January 31, 2002, the
Company was in compliance with the covenant. If the Company continues to
experience significant losses, it may violate the covenant in future
periods. The Company is currently reviewing all of its continuing
operations to reduce its operating losses as well as exploring possible
equity transactions in an effort to bolster its tangible net worth. The
obligations of Oxycal to Bank One with respect to the 1999 Industrial
Revenue Development Bonds have not changed.



|8. | ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND GOODWILL
|-- | ---------------------------------------------------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Effective August 1, 2001, the Company adopted the Financial Accounting
Standards
Board Statement of Financial Accounting Standard (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. Prior
to that date, the Company accounted for impairment of long-lived assets in
accordance with Statement of Financial Accounting Standards (SFAS) No.
121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. SFAS No. 121 required that
long-lived assets be reviewed for impairment whenever events or changes in
circumstances indicated that the book value of the

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| |                                                                                                                                                                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | asset may not have been recoverable. In the quarter ended October 31,
2000, the Company recorded a non-cash charge of $310,000 in the
Nutraceuticals segment to write down the carrying amount of the land and
buildings located at 533 Madison Avenue, Prescott, Arizona to an estimated
fair value related to its anticipated sale. The building was sold in
February 2001.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Companys policy is to review the carrying amounts of long-lived
assets and goodwill whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Such events
might include a significant decline in market share, a significant decline
in profits, rapid changes in technology, significant litigation or other
items. In evaluating the recoverability of long-lived assets,
managements policy is to compare the carrying amounts of such assets (or
asset group) with the estimated future cash flows.



|9. | NEW ACCOUNTING PRONOUNCEMENTS
|-- | -----------------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In May 2000, the Financial Accounting Standards Boards Emerging Issues
Task Force (EITF) released Issue No. 00-14, Accounting for Certain
Sales Incentives. The Issue addresses the recognition, measurement, and
income statement classification for certain sales incentives including
coupons, rebates and free products. The consensus on EITF 00-14 will be
effective for the Company on February 1, 2002. The implementation of this
consensus will require the Company to classify certain sales incentives,
which are currently recorded as selling, general and administrative
expenses as a reduction of net sales. The cost of free products will be
recorded as a reduction of the cost of products sold.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In April 2001, the EITF released Issue No. 00-25, Vendor Income Statement
Characterization of Consideration from a Vendor to a Retailer. The Issue
discusses accounting and income statement classification of costs, other
than those directly addressed in Issue 00-14, that are incurred by a
vendor (typically a manufacturer or distributor) to or on behalf of a
customer (typically a retailer) in connection with the customers purchase
or promotion of the vendors products. Such costs include consideration
given to retailers for space in their stores (slotting fees),
consideration given to obtain favorable display positions in the
retailers stores and other promotional activity such as cooperative
advertising. The Issue addresses the recognition and measurement of such
costs and whether a vendor should classify such costs in its income
statement when incurred as a reduction of revenues or as an expense item.
The consensus on EITF 00-25 will be effective for the Company on February
1, 2002.



| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | The effect of the adoption of EITF-0014 and EITF-00-25 will not
have a material impact on the Companys results of operations.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In June 2001, the Financial Accounting Standards Board issued SFAS No.
141, Business Combinations, and SFAS No. 142, Goodwill and Other
Intangible Assets. SFAS No. 142 changes the accounting for goodwill from
an amortization method to an impairment-only approach. Thus, amortization
of goodwill and intangible assets determined to have indefinite useful
lives, will cease upon adoption of that statement. The Company will adopt
SFAS 142 effective August 1, 2002, as required. The Company expects that
the adoption of SFAS No. 142 will reduce annual amortization expense by
approximately $1.2 million annually pre-tax. The Company is in the
process of analyzing the impact that the impairment analyses will have on
the Companys recorded intangibles.

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|10. | CONVERTIBLE PREFERRED STOCK
|--- | ---------------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In February 2001, the Company issued 100,000 shares of Series B
convertible preferred stock to National Healthcare Manufacturing
Corporation, U.S. as part of the acquisition of the patent rights and the
Antioch, Illinois manufacturing operations for swab products. The
preferred stock is convertible into shares of the Companys common stock
at any time at a conversion ratio of one to one. The holders of the
preferred stock are entitled to receive cumulative quarterly dividends at
a rate of $0.0975 per share per fiscal quarter, payable in arrears. No
dividends were paid during the quarter ended January 31, 2002. Holders of
the preferred shares have no voting rights except as required by
applicable law. The Company has accrued dividends of $9,750 for the
quarter ended January 31, 2002 and has accumulated accrued dividends of
$39,000.



|11. | SEGMENT INFORMATION
|--- | -------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company is organized into three major groups, all of which have
distinct product lines, brand names and are managed as autonomous business
units. The Company has identified the following segments for purposes of
applying SFAS No. 131: Consumer,which includes Zila Pharmaceuticals, Inc.
and the Zilactin® line of products; Professional,which includes the
Peridex® product, the Pro-Series line of products including the Pro-Ties
product, the OraTest® product, the ViziLite product and the IST line of
products; and Nutraceuticals,which includes Oxycal Laboratories, Inc. and
its wholly-owned subsidiary, Inter-Cal, Inc. The Company evaluates
performance and allocates resources to segments based on operating
results. Expenses related to Zila Technical Operations, (the manufacturing
facility for Zila® Tolonium Chloride) and the ongoing OraTest® clinical
study have been combined with the Corporate segment.



| |                                                                                                                                                                                                                                                                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In November 2001, the Company made the decision to dispose of its Zila
Dental Supply reporting segment (see Note 3). The segment information has
been restated to reflect historical segment information as adjusted for
the reclassification of Zila Dental Supply as a discontinued operation.
The assets of the business transferred are included in the total assets of
discontinued operations.



| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | The table below presents information about reported segments as of and for
the six months ended January 31 (in thousands):

|                                   |      |  |          |       |              |  |                |        |           |  |            |        |       |  |   |        |   |  |              |        |  |  |   |        |  
|---------------------------------- | ---- |  | -------- | ----- | ------------ |  | -------------- | ------ | --------- |  | ---------- | ------ | ----- |  | - | ------ | - |  | ------------ | ------ |  |  | - | ------ | -
|                                   |      |  |          |       |              |  |                |        |           |  |            |        |       |  |   |        |   |  | Discontinued |        |  |  |  
|                                   |      |  | Consumer |       | Professional |  | Nutraceuticals |        | Corporate |  | Operations |        | Total
|Net revenues:                      |      |  |          |       |              |  |                |        |           |  |            |        |       |  |   |        |   |  |              |        |  |  |   |       
|                                  
|                                  
|                                  
|                                  
|                                   | 2002 |  | $        | 5,439 |              |  | $              | 2,512  |           |  | $          | 9,953  |       |  | $ | 0      |   |  |              |        |  |  | $ | 17,904 |  
|                                  
|                                  
|                                  
|                                  
|                                   | 2001 |  | $        | 6,621 |              |  | $              | 2,717  |           |  | $          | 7,713  |       |  | $ | 0      |   |  |              |        |  |  | $ | 17,051 |  
|                                  
|                                  
|                                  
|                                  
|Income (loss) before
Income taxes: |      |  |          |       |              |  |                |        |           |  |            |        |       |  |   |        |   |  |              |        |  |  |   |       
|                                  
|                                  
|                                  
|                                  
|                                   | 2002 |  |          | 1,596 |              |  |                | (1,710 | )         |  |            | 670    |       |  |   | (4,448 | ) |  |              |        |  |  |   | (3,892 | )
|                                  
|                                  
|                                  
|                                  
|                                   | 2001 |  |          | 3,145 |              |  |                | (957   | )         |  |            | 24     |       |  |   | (4,371 | ) |  |              |        |  |  |   | (2,159 | )
|                                  
|                                  
|                                  
|                                  
|Depreciation and
amortization:     |      |  |          |       |              |  |                |        |           |  |            |        |       |  |   |        |   |  |              |        |  |  |   |       
|                                  
|                                  
|                                  
|                                  
|                                   | 2002 |  |          | 37    |              |  |                | 634    |           |  |            | 614    |       |  |   | 414    |   |  |              |        |  |  |   | 1,699  |  
|                                  
|                                  
|                                  
|                                  
|                                   | 2001 |  |          | 40    |              |  |                | 554    |           |  |            | 553    |       |  |   | 436    |   |  |              |        |  |  |   | 1,583  |  
|                                  
|                                  
|                                  
|                                  
|Total assets:                      |      |  |          |       |              |  |                |        |           |  |            |        |       |  |   |        |   |  |              |        |  |  |   |       
|                                  
|                                  
|                                  
|                                  
|                                   | 2002 |  |          | 2,438 |              |  |                | 17,605 |           |  |            | 31,931 |       |  |   | 9,751  |   |  |              | 5,746  |  |  |   | 67,471 |  
|                                  
|                                  
|                                  
|                                  
|                                   | 2001 |  |          | 3,430 |              |  |                | 12,830 |           |  |            | 37,165 |       |  |   | 10,088 |   |  |              | 13,516 |  |  |   | 77,029 |  

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|12. | COMMITMENTS AND CONTINGENCIES
|--- | -----------------------------



| |                                                                                                                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On December 19, 2001, the Company and Joseph Hines, its President, reached
a settlement with the Securities and Exchange Commission (the
Commission) relating to certain public statements made by the Company in
January 1999 with respect to the prospects for approval by the Food and
Drug Administration (FDA) of OraTest®, one of the Companys products.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Pursuant to the settlement, the Commission made findings related to an
unsigned draft report that had been prepared by the FDA staff and
delivered to the Company on or about December 28, 1998. The unsigned
draft report recommended against approval of the OraTest® product. The
Commission found that, in public statements made by the Company during the
two-week period subsequent to its receipt of the unsigned draft report and
prior to an FDA advisory committee meeting that was held on January 13,
1999, the Company and Mr. Hines should have disclosed the receipt of the
unsigned draft report. The Commission acknowledged the Companys position
that, at the time, it was represented by experienced FDA counsel who had
advised the Company that its New Drug Application relating to the
OraTest® product was approvable, but the Commission concluded that the
receipt of the unsigned draft report should have been disclosed in the
Companys public statements, and that the failure to do so constituted a
violation of Section 10(b) of the Securities Exchange Act of 1934 (the
Act) and Rule 10b-5 thereunder.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In order to resolve the matter, the Company and Mr. Hines submitted Offers
of Settlement, which the Commission accepted. Without admitting or
denying the Commissions findings, the Company and Mr. Hines consented to
the entry of an Order Instituting Public Administrative Proceedings
pursuant to Section 21C of the Act and the issuance of a Cease-and-Desist
Order prohibiting future violations of such Section and Rule.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In September 2000, counsel advised Zila that its obligation to pay
royalties to Dr. James E. Tinnell, (Tinnell) under a 1980 agreement
ceased as of August 25, 1998 when the patents on the invention expired.
In September 2000, Zila gave notice to Tinnell that it would not continue
paying such royalties and requested reimbursement of royalties paid since
August 1998. After attempts to settle the matter failed, Zila filed suit
in the Federal District Court for the District of Nevada (Zila, Inc. v.
James E. Tinnell, No. CV-S-00-1344), requesting a declaratory judgment
that it had no royalty obligations to Tinnell after August 1998 and
judgment for the overpaid royalties.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Tinnell asserted a counterclaim for royalties since the last payment in
August 2000 and several additional counterclaims based on transactions
between Tinnell and Zila in the 1980s. Counsel have advised Zila that,
based on their investigations and discovery to date, that (i) the
counterclaim for royalties is without merit and (ii) the additional
counterclaims are meritless and, in any event, are time-barred by the
applicable statutes of limitation.



| |                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company is subject to other legal proceedings and claims, which arise
in the ordinary course of business. In the opinion of management, the
amount of ultimate liability with respect to these other actions will not
materially affect the financial position or results of operations of the
Company.

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|13. | COMPREHENSIVE LOSS
|--- | ------------------

Statements of Comprehensive Loss

|                                               |                                                                   |   |                    |        |                  |   |            |         |      |   |            |        |  |   |            |        |  
|---------------------------------------------- | ----------------------------------------------------------------- | - | ------------------ | ------ | ---------------- | - | ---------- | ------- | ---- | - | ---------- | ------ |  | - | ---------- | ------ | -
|                                               |                                                                   |   | Three months ended |        | Six months ended
|                                               |                                                                   |   | January 31,        |        | January 31,     
|                                               |                                                                   |   |                    |        |                 
|                                               |                                                                   |   | 2002               |        | 2001             |   | 2002       |         | 2001
|                                               |                                                                   |  
|Net loss attributable to common shareholders   |                                                                   | $ | (5,983,598         | )      |                  | $ | (1,626,431 | )       |      | $ | (6,984,716 | )      |  | $ | (1,788,986 | )     
|                                               |                                                                   |   |                    |        |                  |   |            |         |      |   |            |        |  |   |            |       
|Other comprehensive income (loss), net of tax: |                                                                   |   |                    |        |                  |   |            |         |      |   |            |        |  |   |            |       
|                                               | Foreign currency translation adjustment                           |   |                    | 53,340 |                  |   |            | (14,558 | )    |   |            | 19,541 |  |   |            | 31,170 |  
|                                               | Unrealized holding losses on securities
arising during the period |   |                    |        |                  |   |            | (620    | )    |   |            |        |  |   |            | (1,870 | )
|                                               |                                                                   |  
|Other comprehensive income (loss)              |                                                                   |   | 53,340             |        |                  |   | (15,178    | )       |      |   | 19,541     |        |  |   | 29,300     |       
|                                               |                                                                   |   |                    |        |                  |   |            |         |      |   |            |        |  |   |            |       
|Comprehensive loss                             |                                                                   | $ | (5,930,258         | )      |                  | $ | (1,641,609 | )       |      | $ | (6,965,175 | )      |  | $ | (1,759,686 | )     
|                                               |                                                                   |  

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|        |  |                                                                                       |  | 
|------- |  | ------------------------------------------------------------------------------------- |  | 
|Item 2. |  | Management's Discussion and Analysis of Financial Condition and Results of Operations

ZILA, INC. AND SUBSIDIARIES

Forward Looking Information

This Report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The words believe, expect, anticipate, intend,
estimate and other expressions that are predictions of or indicate future
events and trends and that do not relate to historical matters identify
forward-looking statements. These forward-looking statements are based largely
on the Companys expectations or forecasts of future events, can be affected by
inaccurate assumptions, and are subject to various business risks and known and
unknown uncertainties, a number of which are beyond the Companys control.
Therefore, actual results could differ materially from the forward-looking
statements contained in this document, and readers are cautioned not to place
undue reliance on such forward-looking statements. The Company undertakes no
obligation to publicly update or revise any forward-looking statements, whether
as a result of new information, future events or otherwise. A wide variety of
factors could cause or contribute to such differences and could adversely
impact revenues, profitability, cash flows and capital needs.

Factors that could cause or contribute to the Companys actual results
differing materially from those discussed herein or for the Companys stock
price to be affected adversely include, but are not limited to: (i) the
Companys failure to maintain compliance with the covenants of its outstanding
debt instruments; (ii) industry trends, including a downturn or slowing of the
growth of the dietary supplement industry and the consumer oral care, OTC and
prescription industries; (iii) the Companys ability to sell its line of saw
palmetto products for a price greater than the carrying value of the inventory;
(iv) increased competition from current competitors and new market entrants;
(v) adverse publicity regarding the industries where the Company markets its
products; (vi) the Companys dependence upon its ability to develop new
products; (vii) the Companys ability to gain or expand distribution within new
or existing channels of trade; (viii) an increase in the cost of obtaining and
maintaining shelf space with major national retailers who demand various forms
of incentives from their suppliers such as slotting fees, coop advertising or
rebates; (ix) adverse changes in government regulations; (x) exposure to
product liability claims; (xi) dependence on significant customers; (xii) the
Companys ability to keep and attract key management employees; (xiii) the
Companys inability to manage growth and execute its business plan; (xiv) sales
and earnings volatility; (xv) volatility of the stock market; (xvi) the
Companys reliance on independent brokers to sell many of its products; (xvii)
the inability of the Company to protect its intellectual property; and (xviii)
a general downturn in the national economy as a whole.

Included among the factors affecting the OraTest® product are (i) the
FDAs ultimate decision regarding the OraTest® product; (ii) the length and
expense of the new clinical study and the FDA review process; (iii) the
limitations on indicated uses for which the OraTest® product may be marketed;
and (iv) if approved, the market reception to the OraTest® product and any
post-marketing reports or surveillance programs to monitor usage or side
effects of the OraTest®product. There can be no assurance that the
forward-looking statements contained in this document will, in fact, transpire
or prove to be accurate. For a more detailed description of these and other
cautionary factors that may affect the Companys future results, please refer
to the Companys Annual Report on Form 10-K for its fiscal year ended July 31,
2001 filed with the Securities and Exchange Commission.

15



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COMPANY OVERVIEW

Zila is a worldwide manufacturer and marketer of pharmaceutical,
biomedical and nutritional products. During the quarter ended January 31,
2002, the Company had three major product groups: Consumer Pharmaceuticals,
Professional Pharmaceutical Products and Nutraceuticals. The Consumer
Pharmaceuticals group consists of over-the-counter products, including the
Zilactin® family of products. The Professional Pharmaceuticals group includes
Peridex® prescription mouth rinse, the OraTest® oral cancer detection system,
the Pro-Series line of products, including the Pro-Ties bundling system for
instrument sterilization, the ViziLite disposable light for illumination of
abnormal oral tissue and the plastic molded products from Innovative Swab
Technologies (IST). The Nutraceuticals group is comprised of Oxycal
Laboratories, Inc. (Oxycal) and its Inter-Cal (Inter-Cal) subsidiary, a
manufacturer and distributor of mineral and botanical products including a
patented and unique form of Vitamin C under the trademark Ester-C® and the
Palmettx botanical line of products.

In February 2001, the Company acquired the patent rights and the Antioch,
Illinois manufacturing operations for swab products from National Healthcare
Manufacturing Corporation, headquartered in Winnipeg, Canada. Intellectual
property, inventory, plus molding, labeling, filling and sealing equipment were
included in the acquisition. The business unit is known as Innovative Swab
Technologies, Inc. Zila paid approximately $2.4 million in a combination of
cash and preferred stock for the unit.

In November 2001, the Company made the decision to dispose of its Zila
Dental Supply reporting segment. In November and December 2001, the Company
sold substantially all of the assets and certain liabilities of the ZDS segment
in two separate transactions. ZDSs full-service assets were sold on November
5, 2001 to Henry Schein, Inc. of Melville, NY (Nasdaq: HSIC) for approximately
$5.8 million in cash. The Company realized a gain from the disposal of the
full service assets of approximately $494,000, net of a current tax expense of
approximately $329,000. Proceeds from the sale were used to repay borrowings
outstanding under the revolving line of credit with Congress Financial
Corporation.

The ZDS mail order operations (assets and liabilities) were sold on
December 4, 2001 to PracticeWares, Inc. of Sacramento, CA for approximately
$8.0 million in one short and two long-term notes. Approximately $5.7 million
of the $8.0 million purchase price (net of post closing adjustments) was due
and payable January 11, 2002. The Company extended the maturity date of the
short-term note, upon payment of accrued and prepaid interest, to February 15,
2002, and further extended the note to March 1, 2002, with interest prepaid
through the new maturity date. The note has not been paid and is currently in default. Zila has
various remedies including the right to affect reconveyance to the Company. As
a result of PracticeWares failure to pay the short term notes, the transaction
to sell the mail order business no longer qualifies as a sale for accounting
purposes and the assets and liabilities of that operation have been classified
as current and shown as net assets and liabilities of business transferred
under contractual arrangements. Operating results of the operation will
continue to be reflected in the income statement as income (loss) from
operation of discontinued Dental Supply Segment. For current and future quarters
for which the business transferral has net income, such net income may be recognized by the
Company to the extent of any cumulative quarterly losses within the same fiscal
year. Similarly, quarterly losses of the business need not be recognized by
the Company except to the extent that they exceed any cumulative quarterly net
income within the same fiscal year.

In March 2002, Zila and PracticeWares agreed, in principle, to restructure the
terms relating to the sale. Under the restructured terms, PracticeWares will
issue Zila a new, secured $8.54 million convertible note, bearing interest at
10 percent per year. Approximately 30 percent of the note is due and payable
in May 2002. That payment to Zila is expected to be financed by an
institutional lending source and will be subject to their approval. The
balance of the note, subject to certain post-closing adjustments, will be due
within five years on an amortization schedule negotiated by the parties. Zila
will receive, as part of the consideration, a 19.9 percent equity interest in
PracticeWares. PracticeWares shareholders will pledge their shares as
security for the note, and guarantees for a portion of the note will be provided by
PracticeWorks, Inc. (AMEX: PRW), and Greg Jones, President of PracticeWares. As part of the transaction,
PracticeWorks, Inc. (a dental practice management software systems provider)
and PracticeWares will enter into a 20-year e-commerce agreement under which
PracticeWares will be able to offer products and services to the PracticeWorks
dental subscriber base. In connection with the e-commerce agreement,
PracticeWorks, Inc. will have an option to purchase all of the PracticeWares
capital stock from its shareholders for the first five years of the e-commerce
agreement at a price equal to the greater of an appraised value or a minimum
value determined by the parties at closing. The e-commerce agreement and the
guarantee from PracticeWorks, Inc. are subject to approval of the PracticeWorks
board of directors.

On December 5, 2001, the Company acquired the world marketing rights
(excluding the Pacific Rim) for the ViziLite chemiluminescent light technology
from Trylon Corporation of Torrance, CA. Under the transaction, the Company
issued 1,625,000 of restricted shares of common stock and placed an additional
375,000 shares of common stock into escrow. Of the 1,625,000 restricted shares,
750,000

16



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##### Table of Contents



shares are restricted within the meaning of Rule 144 under the Securities
Act of 1933, as amended, and may be eligible for sale subject to the holding
period and other requirements of that Rule and the contractual restrictions on
the remaining 875,000 shares will be removed at the earlier of 10 years
following the closing date or the achievement of certain future sales and
government approval milestones. Management has estimated the fair value of the
restricted 875,000 shares to be $1.1 million that is reflected as an addition
to the value of the license acquired of $753,000 and a prepaid research &
development fee of $372,000. The Company will record an adjustment to the fair
value at the date the milestones are achieved. The release of the 375,000
shares in escrow is contingent upon Trylon obtaining regulatory approval of a
product currently under development. Due to the contingent nature of the
approval process, the Company will not record the research and development
costs associated with these shares until approval is obtained.

In addition, the Company entered into a license agreement with Trylon
related to the chemiluminescent light technology that requires the Company to
pay a royalty on sales of the ViziLite product of 10 percent in the first five
years, and five percent in the next five years.

RESULTS OF OPERATIONS

Comparison of the Quarter ended January 31, 2002 with the Quarter ended January 31, 2001

Total net revenues increased 6.2% to $8.9 million for the quarter ended
January 31, 2002, compared to revenues of $8.4 million during the second
quarter of the prior fiscal year.

Consumer Pharmaceuticals had net revenues of $2.6 million for the quarter
ended January 31, 2002, a 10.5% decline over the $2.9 million recorded during
the corresponding quarter last year. The decrease was due primarily to
higher than normal sales resulting from increased promotional discounts offered to customers in January of the previous
year period coupled with the adverse affects on consumer demand caused by the
events of September 11, 2001 and new competitive product introductions during
the current quarter. Several initiatives were started during the quarter in an
effort to increase sales including new package design, new consumer and
professional advertising campaign and increased level of public relations
activities.

Net revenues for Professional Pharmaceuticals (including sales of the
OraTest® product) were $1.1 million, a 30.0% decrease from the $1.5 million
recorded during the prior year quarter. During the prior year quarter,
approximately $483,000 of our revenue was generated from a license agreement
executed during the quarter, whereby the Company granted a customer the right
to use our technology related to Chlorhexidine Gluconate to produce a generic
form of the product for distribution. Excluding the license revenue,
Professional Pharmaceutical sales of products during the current quarter were
approximately equal to the prior year quarter sales but less than expected.
Sales of the Peridex® product decreased 28.1% due to increased pricing
pressures and substitutions of generic equivalents by pharmacists. Sales of
the new Pro-Series of products, which are being marketed directly to dental
professionals, were adversely affected by the events of September 11, 2001, due
to the cancellation of a major trade show for dental professionals and reduced
attendance at two subsequent shows. Sales for the
IST division were $268,000 (excluding $44,000 interdivisional sales).

Net revenues for Inter-Cal for the quarter ended January 31, 2002, were
$5.2 million, a 32.6% increase compared to $3.9 million for the corresponding
2001 fiscal quarter. The increase is attributable to increased radio and
television advertising of the Ester-C® products and an increase in sales of saw
palmetto products. Inter-Cals international sales during the quarter decreased
approximately 48.8% compared to the previous years second quarter.

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For the quarter ended October 31, 2001, cost of products sold was $3.2
million, a 21.4% increase from the $2.6 million recorded in the quarter ended
January 31, 2001. Cost of products sold as a percentage of net revenues
increased to 35.9% in the quarter ended January 31, 2002 from 31.4 % in the
quarter ended January 31, 2001. The increase for the quarter primarily
reflects (i) the effect of the non-recurring licensing fees which have no cost
associated with it; (ii) the addition of IST which was not included in the
prior year quarter; and (iii) the increase in sales of Palmettx products that
have a higher cost of production as a percentage of revenue than the other
product lines of the Company.

Cost of products sold as a percentage of net revenues for Consumer
Pharmaceuticals increased to 26.0% in the quarter ended January 31, 2002, from
24.5% in the quarter ended January 31, 2001. The increase for the quarter is
the result of a change in the mix of products sold. Cost of products sold as
a percentage of net product sales for Professional Pharmaceuticals increased to
42.1% for the quarter ended January 31, 2002 from 20.6% in the quarter ended
January 31, 2001. The increase is due primarily to the higher costs to
manufacture ISTs products and the addition of the ViziLite product line
compared to the products in the group last year.

Cost of products sold as a percentage of net revenues for Inter-Cal
decreased to 37.7% in the quarter ended January 31, 2002 from 39.6% in the
corresponding quarter of the previous year. The decrease was attributable to a
higher volume of products produced during the current quarter when compared to
the previous year quarter. During the prior year quarter, InterCal incurred an
increase in production costs related to the validation of the new manufacturing
equipment in the newly built facility. During the second quarter of 2002,
Inter-Cal reduced the carrying value of one of its saw palmetto products by
$55,000 because the sales price of the product was less than its carrying
value. Inter-Cal increased prices to customers in February 2002 for saw
palmetto products. However, if Inter-Cal is unsuccessful in its efforts to
sell the Palmettx products at higher prices and market conditions force it to
sell certain Palmettx products below cost, then the Company may be required to
take an additional charge in future quarters for the write-down to net
realizable value of the Palmettx inventory. As of January 31, 2002, Inter-Cal
had approximately $4.5 million of Palmettx inventory (raw material and
finished goods).

The Company incurred selling, general and administrative expenses of $6.8
million, or 76.5% of net revenues during the second quarter of fiscal year
2002, compared to $5.7 million, or 68.3% of net revenue in the same period in
fiscal 2001. The increase is due primarily to increased marketing and
advertising at Consumer Pharmaceuticals and Inter-Cal and the inclusion of the
costs for IST and the ViziLite product. In addition, salaries and related
expenses as well as building and equipment rental costs increased at the Zila
Technical Operations manufacturing facility in Phoenix, Arizona as they
performed more product testing and prepared the facility for the production of
the ViziLite product kits.

Research and development expenses decreased $320,000, or approximately
29%, from $1.1 million in the second quarter of fiscal year 2001 to $789,000
for the same period in fiscal year 2002. The decrease is primarily due to a
decrease in expenses related to the cost of the clinical study associated with
the Companys ongoing efforts to obtain FDA approval of the OraTest® product.

Depreciation and amortization expenses increased slightly to $864,000 in
the second quarter of fiscal year 2002 from $810,000 for the same period in
fiscal year 2001. The increase is due primarily to the increased depreciation
of assets associated with Inter-Cals new manufacturing facility and the
inclusion of the costs at IST.

The Company recorded interest expense of $89,000 for the quarter ended
January 31, 2002

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compared to $144,000 in the same period of the previous year. The decrease was
attributable to decreased bank borrowings and debt obligations during the
current quarter as compared to the previous year period.

At the end of each fiscal quarter, the Company makes its best estimate of
the effective tax rate expected to be applicable for the full fiscal year. The
rate so determined is used in providing for income taxes on a current
year-to-date basis. The rate is revised, if necessary, as of the end of each
quarter during the fiscal year to the Companys best estimate of its annual
effective tax rate. In the three months ended January 31, 2002, the Company
recorded a tax benefit based on the effective tax rate and offset the tax
benefit with an increase in the deferred tax asset valuation reserve. In
addition, the Company recorded income tax expense of $3.2 million primarily due
to an increase in the valuation reserve related to the Companys deferred tax
assets. In the three months ended January 31, 2001, the Company recorded a tax
benefit of $335,000.

For the quarter ended January 31, 2002, the Company had a net loss from
continuing operations of $6.1 million compared to net loss of $1.6 million for
the prior year quarter. As stated above, the increase in net loss is primarily
attributable to lower than expected sales at Professional Pharmaceuticals,
increased cost of products sold, increased selling, general and administrative
expenses and increased income tax expense during the current quarter.

Comparison of the First Six Months of 2002 with the First Six Months of 2001

Total net revenues increased 5.0% to $17.9 million for the six months
ended January 31, 2002, compared to revenues of $17.1 million for the six
months ended January 31, 2001.

Consumer Pharmaceuticals had net revenues of $5.4 million for the six
months ended January 31, 2002, a 17.8% decline over the $6.6 million recorded
during the corresponding period last year. The decrease was due primarily to
the use of discount programs in the corresponding period last year, several new
competitive product entries into the market and the adverse affects on consumer
demand caused by the events of September 11, 2001.

Net revenues for Professional Pharmaceuticals (including sales of the
OraTest® product) decreased 7.5% from $2.7 million during the six months ended
January 31, 2001 to $2.5 million for the six months ended January 31, 2002.
The prior year period includes $483,000 of license revenue generated from an
agreement executed during the quarter, whereby the Company granted a customer
the right to use its technology related to Chlorhexidine Gluconate to produce a
generic form of the product for distribution. Excluding the license revenue,
sales of Professional Products during the current six-month period increased
9.2% when compared to the prior year period. The increase was due to the
inclusion of IST sales of $563,000 (excluding $243,000 of interdivisional
sales) and the sales of the ViziLite product, which were not part
of the segment in the prior year period.

Net revenues for Inter-Cal for the six months ended January 31, 2002, were
$10.0 million, a 29.0% increase when compared to the $7.7 million for the
corresponding period in fiscal year 2001. The increase is attributable to an
aggressive radio and television advertising campaign for Ester-C® products
during the current period. Inter-Cals international sales decreased 3.5%
during the first six months of the current fiscal year as compared to the
previous year amount as international customers have excess inventory levels.

For the six months ended January 31, 2002, cost of products sold was $6.3
million, a 20.8%

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increase from $5.2 million for the six months ended January 31, 2002. Cost of
products sold as a percentage of net revenues increased to 35.3% in the six
months ended January 31, 2002 from 30.7% in the corresponding 2001 period. The
increase for the period reflects primarily the inclusion of IST and the
ViziLite product costs during the current period, both of which have higher
manufacturing costs as a percentage of revenue and the inclusion of
non-recurring licensing fees in the prior year quarter

Cost of products sold as a percentage of net revenues for Consumer
Pharmaceuticals increased slightly to 24.8% in the six months ended January 31,
2002, compared to 23.1% for the corresponding period in fiscal 2001. The
increase for the period is a result of a change in the mix of products sold.
Cost of products sold as a percentage of net product sales for Professional
Pharmaceuticals increased to 38.1% in the six months ended January 31, 2002,
compared to 22.3% for the corresponding period in fiscal 2002. The increase is
due primarily to the addition of IST and ViziLite product costs to the segment
during the period.

Cost of products sold as a percentage of net revenues for Inter-Cal
increased slightly to 38.3% in the six months ended January 31, 2002 from 36.6%
in the six months ended January 31, 2001. The increase was caused by the
higher percentage of sales of the Palmettx botanical line of products, which
had a lower contribution margin than the Ester-C® line of products during the
period.

The Company incurred selling, general and administrative expenses of $12.1
million, or 67.6% of net revenues during the first six months of fiscal year
2002 compared to $10.5 million, or 61.7% of net revenue in the same period in
fiscal 2001. The increase in selling, general and administrative expenses is
attributable to increased marketing and selling expenses at Inter-Cal and ZCP,
the addition of IST and the ViziLite product costs and increased expenses at
the Zila Technical Operations manufacturing facility due to the anticipated
ViziLite product production and increased product testing.

Research and development expenses decreased $116,000 or 7.9%, from the
$1.5 million incurred in the first six months of fiscal year 2001 to $1.4
million for the same period in fiscal year 2002. The decrease was primarily
due to a decrease in expenses related to research and clinical activities
associated with the OraTest® product.

Depreciation and amortization expenses increased $116,000 from $1.6
million in the first six months of fiscal year 2001 to $1.7 million for the
same period in fiscal year 2002. The increase is due primarily to the increase
in the depreciation of assets associated with Inter-Cals new manufacturing
facility that were placed in service during the second half of 2001 and the
addition of IST costs.

In October 2000, the Company recorded a non-cash impairment charge of
$310,000 to write down the carrying value of the land and buildings located at
533 Madison Avenue, Prescott, Arizona to an estimated fair value related to its
anticipated sale. The building was sold in March 2001.

The Company recorded interest expense of $279,000 for the six months ended
January 31, 2002 compared to $167,000 in the same period of the previous year.
The increase was attributable to increases in debt obligations incurred during
the current year period as compared to the previous year period.

In the six months ended January 31, 2002, the Company recorded a tax
benefit based on the effective tax rate and offset the tax benefit with an
increase in the deferred tax asset valuation reserve.
In addition, the Company recorded income tax expense of $3.2 million during the
current six-month period primarily due to an increase in the valuation
allowance related to the Companys deferred tax assets. In the six months
ended January 31, 2001, the Company recorded an income tax benefit of

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$335,000. The Companys effective tax rate for the prior year six-month period
is significantly lower than the statutory rate due primarily to the
non-deductibility of foreign operating losses and non-deductible amortization
of intangible assets.

LIQUIDITY AND CAPITAL RESOURCES

At January 31, 2002, the Companys primary sources of liquidity included
cash and cash equivalents of $431,000 and the line of credit discussed below.
Working capital decreased to $14.7 million at January 31, 2002 from $16.4
million at July 31, 2001, but the current ratio increased to 2.4 at January 31,
2002 from 2.0 at July 31, 2001. The primary reason for the decrease in working
capital is the decrease in accounts receivable and inventories related to the
discontinuance of the Dental Supply segment and the losses incurred during the
period.

Net cash provided by operating activities was $395,000 during the six
months ended January 31, 2002, attributable to the net loss of $7.0 million
offset by changes in operating assets and liabilities totaling $5.2 million
and by non-cash items of $2.2 million. Significant changes in
operating assets and liabilities were primarily comprised of (i) a decrease in
inventory of $1.6 million related primarily to the increased sales of the
Palmettx and Ester-C® products and lower purchases at Consumer
Pharmaceuticals; and (ii) an increase in prepaid expenses and other assets of
$864,000 primarily due to the renewal of insurance policies and the increase in
deferred financing costs incurred during the period.

Net cash provided by investing activities was $3.1 million related
primarily to the proceeds received from the sale of the full service Dental
Supply assets of $5.8 million offset by the net transfers of assets and
liabilities of the discontinued operations, the capital purchases, the purchase
of the Peridex® product distribution rights for Western Europe and patent
filings for Inter-Cal.

Net cash used in financing activities was $4.4 million. Significant
changes were: (i) the outstanding balance of the line of credit was reduced by
$3.9 million; (ii) the building loan with Bank One, Arizona, NA of
approximately $277,000 was paid in full; and (iii) the bonds payable related to
the new Inter-Cal facility was reduced by approximately $213,000.

At January 31, 2002, the Company had income tax net operating loss
carryforwards of approximately $17 million, which expire in years 2007 through
2022. The Companys ability to utilize these income tax net operating loss
carryforwards may be impaired if the Company continues to incur continuing
operating losses.

On August 27, 2001, the Company and Congress Financial Corporation
(Congress) entered into a Loan and Security Agreement (the Agreement) under
which Congress provides a $12 million revolving line of credit (the Line) to
the Company at an interest rate equal to the prime rate plus 3/4 percent. A
portion of the available funds from the Line were used to pay off in full the
line of credit and building loan due to Bank One, Arizona, NA, totaling
approximately $6.4 million. The amount of funds available to the Company from
the Line is based upon a percentage of the value of eligible receivables and
inventory and was $5.6 million at January 31, 2002, of which, borrowings of
$2.1 million were outstanding.

The obligations under the Agreement are collateralized by various assets,
including, but not limited to, trade accounts receivable, inventories,
equipment and intangible assets of the Company and of certain of its operating
subsidiaries. Zila and all of its direct and indirect operating subsidiaries
guarantee the obligations under the Agreement. The Agreement expires August
17, 2004; however, the Line is classified as current because of certain
provisions required by Congress. Under the Agreement,

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the Company is required to comply with a financial covenant based on an
adjusted tangible net worth calculation. At January 31, 2002, the Company was
in compliance with the covenant. If the Company continues to experience
significant losses, it may violate the covenant in future periods. The Company
is currently reviewing all of its continuing operations to reduce its operating
losses as well as exploring possible equity transactions in an effort to
bolster its tangible net worth. The obligations of Oxycal to Bank One with
respect to the 1999 Industrial Revenue Development Bonds have not changed.

During October 2000, Inter-Cal moved into its new manufacturing and
laboratory facility in Prescott, AZ. The facility was financed through a
transaction with The Industrial Development Authority of the County of Yavapai
(the Authority) in which the Authority issued $5.0 million in Industrial
Development Revenue Bonds (the Bonds), the proceeds of which were loaned to
Oxycal for the construction of the facility. The Bond proceeds were held by the
trustee, Bank One, Arizona, until such time as invoices for building
construction and new equipment were submitted for payment. The Bonds consisted
of $3.9 million Series A and $469,000 of Taxable Series B, which, as of January
31, 2002 carried interest rates of 1.7% and 2.0%, respectively and have a
maturity of 20 years. In connection with the issuance of the Bonds, the
Authority required that Oxycal obtain, for the benefit of the Bondholders, an
irrevocable direct-pay letter of credit to secure payment of principal and
interest. Zila guarantees the letter of credit.

The Company believes that cash generated from its operations, the sale of
the assets of Zila Dental Supply, its investing activities and the availability
of cash under its line of credit are sufficient to finance its current level of
operations and anticipated capital expenditures. When the Company sold the mail
order operations of ZDS to PracticeWares, Inc. in December 2001, the Company
expected to receive approximately $5.7 million in January 2002, of which,
approximately $3 million was to be invested in the on-going OraTest® Phase III
clinical trial. Due to the restructuring of the PracticeWares transaction, the
Company did not receive the $5.7 million as expected. The Company will require additional
financing to support the production and future OraTest®® clinical, regulatory,
manufacturing and marketing costs or to make any significant acquisitions.
There can be no assurance that such funds will be available on terms acceptable
to the Company.




Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk refers to the potential effects of unfavorable changes in
certain prices and rates on the Companys financial results and conditions,
primarily foreign currency exchange rates and interest rates on debt
obligations. The Company transacts business in various foreign countries.
Foreign currency exposures are primarily, but not limited to, vendor and
customer payments and inter-company balances in currencies other than the
functional currency. Fluctuations in foreign currencies could have a material
adverse effect on the Companys results of operations.

The Company is exposed to interest rate fluctuations on its Industrial
Development Revenue Bonds and the line of credit with Congress as the interest
charged is based on variable rates. The Bonds bear interest based on a
floating rate and adjusted weekly by Banc One Capital Markets. Interest on the
outstanding balance of the line of credit is charged at the Index plus 3/4 %.
The Company does not trade in derivative financial instruments. The Company
does not believe that near-term changes in foreign currency exchange rates or
interest rates will have a material effect on its future earnings, fair values
or cash flows.

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Part II  Other Information




ITEM 1.  LEGAL PROCEEDINGS

On December 19, 2001, the Company and Joseph Hines, its President, reached
a settlement with the Securities and Exchange Commission (the Commission)
relating to certain public statements made by the Company in January 1999 with
respect to the prospects for approval by the Food and Drug Administration
(FDA) of OraTest®, one of the Companys products.

Pursuant to the settlement, the Commission made findings related to an
unsigned draft report that had been prepared by the FDA staff and delivered to
the Company on or about December 28, 1998. The unsigned draft report
recommended against approval of the OraTest® product. The Commission found
that, in public statements made by the Company during the two-week period
subsequent to its receipt of the unsigned draft report and prior to an FDA
advisory committee meeting that was held on January 13, 1999, the Company and
Mr. Hines should have disclosed the receipt of the unsigned draft report. The
Commission acknowledged the Companys position that, at the time, it was
represented by experienced FDA counsel who had advised the Company that its New
Drug Application relating to the OraTest® product was approvable, but the
Commission concluded that the receipt of the unsigned draft report should have
been disclosed in the Companys public statements, and that the failure to do
so constituted a violation of Section 10(b) of the Securities Exchange Act of
1934 (the Act) and Rule 10b-5 thereunder.

In order to resolve the matter, the Company and Mr. Hines submitted Offers
of Settlement, which the Commission accepted. Without admitting or denying the
Commissions findings, the Company and Mr. Hines consented to the entry of an
Order Instituting Public Administrative Proceedings pursuant to Section 21C of
the Act and the issuance of a Cease-and-Desist Order prohibiting future
violations of such Section and Rule.

In September 2000, counsel advised Zila that its obligation to pay
royalties to Dr. James E. Tinnell, (Tinnell) under a 1980 agreement ceased as
of August 25, 1998 when the patents on the invention expired. In September
2000, Zila gave notice to Tinnell that it would not continue paying such
royalties and requested reimbursement of royalties paid since August 1998.
After attempts to settle the matter failed, Zila filed suit in the Federal
District Court for the District of Nevada (Zila, Inc. v. James E. Tinnell, No.
CV-S-00-1344), requesting a declaratory judgment that it had no royalty
obligations to Tinnell after August 1998 and judgment for the overpaid
royalties.

Tinnell asserted a counterclaim for royalties since the last payment in
August 2000 and several additional counterclaims based on transactions between
Tinnell and Zila in the 1980s. Counsel have advised Zila that, based on their
investigations and discovery to date, that (i) the counterclaim for royalties
is without merit and (ii) the additional counterclaims are meritless and, in
any event, are time-barred by the applicable statutes of limitation.

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

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ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On December 5, 2001, the Company acquired the world marketing rights
(excluding the Pacific Rim) for the ViziLite chemiluminescent light
technology from Trylon Corporation of Torrance, CA. for 2,000,000 shares
of unregistered common stock that were issued pursuant to Section 4(2) of
the Securities Act of 1933. Under the transaction, the Company issued
1,625,000 of restricted shares of common stock and placed an additional
375,000 shares of common stock into escrow. Of the 1,625,000 restricted
shares, 750,000 shares are restricted within the meaning of Rule 144 under
the Securities Act of 1933, as amended, and may be eligible for sale
subject to the holding period and other requirements of that Rule. The
contractual restrictions on the remaining 875,000 shares will be removed at
the earlier of 10 years following the closing date or the achievement of
certain future sales and government approval milestones.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

Not Applicable




ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.



| | (a) |  | The Company held its annual meeting of stockholders in Phoenix,
Arizona on December 5, 2001. A total of 40,427,674 shares of common
stock, 92.6% of the outstanding shares, were represented in person
or by proxy.
| | --- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (b) |  | The following seven directors were each elected to a one-year
term expiring in 2002:                                                                                                                               

|                       |  |                  |            |          |  |  |           | 
|---------------------- |  | ---------------- | ---------- | -------- |  |  | --------- | 
|                       |  | Number of Shares
|                       |  |                 
|Name                   |  | For              |            | Withheld
|                       |  |                  |            |         
|Joseph Hines           |  |                  | 39,685,742 |          |  |  | 741,932   | 
|Carl A. Schroeder      |  |                  | 39,797,721 |          |  |  | 629,953   | 
|Michael S. Lesser      |  |                  | 39,710,418 |          |  |  | 717,256   | 
|Curtis M. Rocca, III   |  |                  | 38,987,699 |          |  |  | 1,439,975 | 
|Christopher D. Johnson |  |                  | 39,774,714 |          |  |  | 652,960   | 
|Kevin J. Tourek        |  |                  | 39,038,190 |          |  |  | 1,389,484 | 
|H. Richard Grisham     |  |                  | 39,106,070 |          |  |  | 1,321,604 | 



| | (c) |  | The Companys stockholders approved the selection of Deloitte &
Touche LLP as auditors for the Company for its 2002 fiscal year as
follows: 40,037,254 shares voted in favor; 243,914 shares voted
against; and 146,524 shares abstained (including broker non-votes).
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




ITEM 5. OTHER INFORMATION

Not applicable




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | (a) |  | Exhibits
| | --- |  | --------

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| | (b) |  | Reports on Form 8-K
| | --- |  | -------------------



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During the quarter ended January 31, 2002, the Company filed two
Current Reports on Form 8-K. The first Report, dated December 4,
2001, contained information pursuant to Item 7, Financial Statements
and Exhibits, provided pro forma financial information of the
Company in connection with the sale of substantially all of the
assets and certain liabilities in its Dental Supply segment. The
second Report dated December 19, 2001, contained information
pursuant to Item 5, Other Events, regarding the entry of an Order
Instituting Public Administrative Proceedings pursuant to Section
21C of the Securities Act of 1934 and the issuance of a
Cease-and-Desist Order relating to the Company and Mr. Hines, its
President.
|
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                




SIGNATURES

Pursuant to the requirements 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.

|                     |  |                                                                                                                                      
|-------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------
|Date: March 18, 2002 |  | By: /s/ Joseph Hines
Joseph Hines
President, Chairman of the Board
(Principal Executive Officer)                                     
|                    
|                     |  |                                                                                                                                      
|                    
|                     |  | By: /s/ Bradley C. Anderson
Bradley C. Anderson
Vice President and Chief
Financial Officer (Principal
Financial & Accounting Officer)

25