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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the quarterly period ended December 28, 2002

OR

For the transition period from                      to                     

Commission File Number 0-20080

GALEY & LORD, INC.

(Exact name of registrant as specified in its charter)

212/465-3000

(Registrant’s telephone number, including area code)

Not Applicable

(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 x No ¨.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes ¨ No x.

Common Stock, $.01 Par Value—11,996,965 shares as of February 7, 2003.

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INDEX

GALEY & LORD, INC.

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PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands)

See accompanying notes to consolidated financial statements.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(Amounts in thousands except per share data)

See accompanying notes to consolidated financial statements.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(Amounts in thousands)

See accompanying notes to consolidated financial statements.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing

On February 19, 2002 (the “Filing Date”), Galey & Lord, Inc. (the “Company”) and each of its domestic subsidiaries (together with the Company, the “Debtors”) filed voluntary petitions for reorganization (the “Chapter 11 Filings” or the “Filings”) under Chapter 11 of Title 11, United States Code (the “Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (Case Nos. 02-40445 through 02-40456 (ALG)). The Chapter 11 Filings pending for the Debtors are being jointly administered for procedural purposes only. The Debtors’ direct and indirect foreign subsidiaries and foreign joint venture entities did not file petitions under Chapter 11 and are not the subject of any bankruptcy proceedings.

During the pendency of the Filings, the Debtors remain in possession of their properties and assets and management continues to operate the businesses of the Debtors as debtors-in-possession pursuant to Sections 1107(a) and 1108 of the Bankruptcy Code. As debtors-in-possession, the Debtors are authorized to operate their businesses, but may not engage in transactions outside of the ordinary course of business without the approval of the Bankruptcy Court, after notice and the opportunity for a hearing.

On the Filing Date, the Debtors filed a motion seeking authority for the Company to enter into a credit facility of up to $100 million in debtor-in-possession (“DIP”) financing with First Union National Bank (the “Agent”) and Wachovia Securities, Inc. On February 21, 2002, the Bankruptcy Court entered an interim order approving the credit facility and authorizing immediate access of up to $30 million. On March 19, 2002, the Bankruptcy Court entered a final order approving the entire $100 million DIP financing. Effective September 24, 2002, the Company exercised its right, as permitted under the DIP Financing Agreement, to permanently reduce such maximum amount of revolving credit borrowings from $100 million to $75 million.

Under the terms of the final DIP financing agreement (the “DIP Financing Agreement”), the Company, as borrower, may make revolving credit borrowings (including up to $15 million for post-petition letters of credit) in an amount not exceeding the lesser of $100 million (effective September 24, 2002, it was permanently reduced to $75 million) or the Borrowing Base (as defined in the DIP Financing Agreement). The DIP Financing Agreement will terminate and the borrowings thereunder will be due and payable upon the earliest of (i) August 19, 2003, (ii) the date of the substantial consummation of a plan of reorganization that is confirmed pursuant to an order by the Bankruptcy Court or (iii) the acceleration of the revolving credit loans made by any of the banks who are a party to the DIP Financing Agreement and the termination of the

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing (Continued)

total commitment under the DIP Financing Agreement pursuant to the DIP Financing Agreement. Amounts borrowed under the DIP Financing Agreement bear interest at the rate per annum at the Company’s option, of either (i) (a) the higher of the prime rate or the federal funds rate plus .50% plus (b) a margin of 2.00% or (ii) LIBOR plus a margin of 3.25%. There is an unused commitment fee of either (A) at such time as First Union National Bank is no longer the sole bank, at the rate of (i) .75% per annum on the average daily unused total commitment at all times during which the average total commitment usage is less than 25% of the total commitment and (ii) .5% per annum on the average daily unused total commitment at all times during which the average total commitment usage is more than or equal to 25% of the total commitment; or (B) at all times that First Union National Bank is the sole bank, at a rate of .50% per annum on the average daily unused total commitment. There are letter of credit fees payable to the Agent equal to LIBOR plus 3.25% on the daily average letters of credit outstanding and to a fronting bank, its customary fees plus .25% for each letter of credit issued by such fronting bank.

Borrowings under the DIP Financing Agreement are guaranteed by each of the Debtor subsidiaries. In general, such borrowings constitute allowed super-priority administrative expense claims, and are secured by (i) a perfected first priority lien pursuant to Section 364(c)(2) of the Bankruptcy Code, upon all property of the Company and the Debtor subsidiaries that was not subject to a valid, perfected and non-avoidable lien on the Filing Date, (ii) a perfected junior lien, pursuant to Section 364(c)(3) of the Bankruptcy Code upon all property of the Company and the Debtor subsidiaries already subject to valid, perfected, non-avoidable liens, and (iii) a perfected first priority senior priming lien, pursuant to Section 364(d)(1) of the Bankruptcy Code, upon all property of the Company and the Debtor subsidiaries already subject to a lien that presently secures the Company’s and the Debtor subsidiaries’ pre-petition indebtedness under the existing pre-petition credit agreement, whether created prior to or after the Filing Date (subject to certain specific existing or subsequently perfected liens). This security interest is subject to certain explicit exceptions.

The DIP Financing Agreement contains covenants restricting the Company and the Debtor subsidiaries from consolidating or merging with and into another person, disposing of assets, incurring additional indebtedness and guarantees, creating liens and encumbrances on properties, modifying its or their business, making capital expenditures in excess of $22.5 million through the maturity date or $15.2 million during any 12 month period, declaring and paying dividends, making investments, loans or

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing (Continued)

advances, and creating super-priority claims. There are certain limitations on affiliate transactions and on costs and expenses incurred in connection with the closing of production facilities. The DIP Financing Agreement also requires the Company and the Debtor subsidiaries to achieve certain levels of EBITDA (as defined) as specified therein. At December 28, 2002, the Company was in compliance with the covenants of the DIP Financing Agreement.

The DIP Financing Agreement also provides for the mandatory prepayment of all or a portion of outstanding borrowings upon repatriation of funds from foreign subsidiaries or the sale of assets, or in the event outstanding loans exceed the Borrowing Base.

The Bankruptcy Court has approved payment of certain of the Debtors’ pre-petition obligations, including, among other things, employee wages, salaries, and benefits, and certain critical vendor and other business-related payments necessary to maintain the operation of their businesses. The Debtors have retained, with Bankruptcy Court approval, legal and financial professionals to advise the Debtors in the bankruptcy proceedings and the restructuring of their businesses, and certain other “ordinary course” professionals. From time to time the Debtors may seek Bankruptcy Court approval for the retention of additional professionals.

By orders dated June 6, 2002, and July 24, 2002, the Bankruptcy Court authorized the implementation of various employee programs for the Debtors. These programs include:

Stay Bonus and Emergence Plans—These plans provide for payments totaling $5.2 million for 62 employees including executive officers. Payments under the Stay Bonus Plan are in four equal payments beginning in August 2002 and ending the later of June 2003 or upon emergence. The Emergence Plan provides for a single payment upon emergence.

Enhanced Severance Program—Pursuant to this program, certain employees, including executive officers, are entitled to “enhanced” severance payments under certain terms and conditions.

Discretionary Transition Payment Plan—This plan allows the Debtors to offer incentives to certain employees during a transition period at the end of which such employees would be terminated, in the event such incentives become necessary (the Debtors have no current plans to significantly reduce headcount).

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing (Continued)

Discretionary Retention Pool—This plan provides the Chief Executive Officer discretionary authority to offer incentives to employees (including new employees) not otherwise participating in other portions of the plan.

Performance Incentive Plan—The Debtors are negotiating with their senior lenders and their unsecured creditors committee a proposed performance incentive plan, pursuant to which certain employees, including executive officers, would be entitled to an additional bonus in the event certain personal and/or company performance goals were achieved.

The Debtors must, subject to Bankruptcy Court approval and certain other limitations, assume, assume and assign, or reject each of their executory contracts and unexpired leases. In this context, “assumption” means, among other things, re-affirming their obligations under the relevant lease or contract and curing all monetary defaults thereunder. In this context, “rejection” means breaching the relevant contract or lease as of the Filing Date, being relieved of on-going obligations to perform under the contract or lease, and being liable for damages, if any, for the breach thereof. Such damages, if any, are deemed to have accrued prior to the Filing Date by operation of the Bankruptcy Code. The Bankruptcy Court has entered two orders collectively approving the rejection of one executory contract and several unexpired leases. In addition, under the Bankruptcy Code, the Debtors must assume, assume and assign, or reject all unexpired leases of non-residential real property for which a Debtor is lessee within 60 days from the Filing Date. By orders dated April 29, 2002, August 16, 2002 and December 11, 2002, the Bankruptcy Court extended this deadline up through and including April 16, 2003. The Debtors are in the process of reviewing their remaining executory contracts to determine which, if any, they will reject. At this time the Debtors cannot reasonably estimate the ultimate liability, if any, that may result from rejecting and/or assuming executory contracts or unexpired leases, and no provisions have yet been made for these items.

The Bankruptcy Court established October 1, 2002 as the “bar date” as of which all claimants are required to submit and characterize claims against the Debtors. The Debtors are currently in the process of reviewing the claims that were filed against the Company. The ultimate amount of the claims allowed by the Court against the Company could be significantly different than the amount of the liabilities recorded by the Company.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing (Continued)

The consummation of a plan or plans of reorganization (a “Plan”) is the principal objective of the Chapter 11 Filings. A Plan would, among other things, set forth the means for satisfying claims against and interests in the Company and its Debtor subsidiaries, including setting forth the potential distributions on account of such claims and interests, if any. Pursuant to the Bankruptcy Code, the Debtors had the exclusive right for 120 days from the Filing Date (through and including June 18, 2002) to file a Plan, and for 180 days from the Filing Date (through and including August 17, 2002) to solicit and receive the votes necessary to confirm a Plan. As of the date hereof, the Bankruptcy Court had entered three orders collectively extending the Debtors’ exclusive right to file a plan through and including March 31, 2003, and extending the Debtors’ exclusive right to solicit acceptances of such plan through and including June 2, 2003. Both of these exclusivity periods may be further extended by the Bankruptcy Court for cause. If the Debtors fail to file a Plan during the exclusive filing period or if the Debtors fail to obtain the requisite acceptance of such Plan during the exclusive solicitation period, any party-in-interest, including a creditor, an equity holder, a committee of creditors or equity holders, or an indenture trustee, may file its own Plan for the Debtors. Confirmation of a Plan is subject to certain statutory findings by the Bankruptcy Court. Subject to certain exceptions as set forth in the Bankruptcy Code, confirmation of a Plan requires, among other things, a vote on the Plan by certain classes of creditors and equity holders whose rights or interests are impaired under the Plan. If any impaired class of creditors or equity holders does not vote to accept the Plan, but all of the other requirements of the Bankruptcy Code are met, the proponent of the Plan may seek confirmation of the Plan pursuant to the “cram down” provisions of the Bankruptcy Code. Under these provisions, the Bankruptcy Court may still confirm a Plan notwithstanding the non-acceptance of the Plan by an impaired class, if, among other things, no claim or interest receives or retains any property under the Plan until each holder of a claim senior to such claim or interest has been paid in full. As a result of the amount of pre-petition indebtedness and the availability of the “cram down” provisions, the holders of the Company’s capital stock may receive no value for their interests under any Plan. Because of such possibility, the value of the Company’s outstanding capital stock and unsecured instruments are highly speculative. In addition, there can be no assurance that a Plan will be proposed by the Debtors or confirmed by the Bankruptcy Court, or that any such Plan will be consummated.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing (Continued)

It is not possible to predict the length of time the Company will operate under the protection of Chapter 11 and the supervision of the Bankruptcy Court, the outcome of the bankruptcy proceedings in general, or the effect of the proceedings on the business of the Company or on the interest of the various creditors and stakeholders. Since the Filing Date, the Debtors have conducted business in the ordinary course. Management is in the process of evaluating their operations as part of the development of a Plan. During the pendency of the Chapter 11 Filings, the Debtors may, with Bankruptcy Court approval, sell assets and settle liabilities, including for amounts other than those reflected in the financial statements. The administrative and reorganization expenses resulting from the Chapter 11 Filings will unfavorably affect the Debtors’ results of operations. In addition, under the priority scheme established by the Bankruptcy Code, most, if not all, post-petition liabilities must be satisfied before most other creditors or interest holders, including stockholders, can receive any distribution on account of such claim or interest.

The accompanying consolidated financial statements are presented in accordance with American Institute of Certified Public Accountants Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (“SOP 90-7”), assuming that the Company will continue as a going concern. The Company is currently operating under the jurisdiction of Chapter 11 of the Bankruptcy Code and the Bankruptcy Court, and continuation of the company as a going concern is contingent upon, among other things, its ability to formulate a Plan which will gain approval of the requisite parties under the Bankruptcy Code and confirmation by the Bankruptcy Court, its ability to comply with the DIP Financing Agreement, and its ability to return to profitability, generate sufficient cash flows from operations, and obtain financing sources to meet future obligations. These matters raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might result from the outcome of these uncertainties.

In the Chapter 11 Filings, substantially all unsecured liabilities as of the Filing Date are subject to compromise or other treatment under a Plan which must be confirmed by the Bankruptcy Court after submission to any required vote by affected parties. Generally, all actions to enforce or otherwise effect repayment of pre-petition liabilities, as well as all

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE A—Bankruptcy Filing (Continued)

pending litigation against the Debtors, are stayed while the Debtors continue their business operations as debtors-in-possession. The ultimate amount of and settlement terms for liabilities subject to compromise are subject to an approved Plan and accordingly are not presently determinable. The principal categories of obligations classified as liabilities subject to compromise under the Chapter 11 Filings as of December 28, 2002 are identified below (in thousands):

Pursuant to SOP 90-7, professional fees associated with the Chapter 11 Filings are expensed as incurred and reported as reorganization items. Interest expense is reported only to the extent that it will be paid during the Chapter 11 Filings or that it is probable that it will be an allowed claim. The Company recognized a charge of $3.4 million associated with the Chapter 11 Filings for the three months ended December 28, 2002, respectively. Of these charges, $1.8 million were for fees payable to professionals retained to assist with the Chapter 11 Filings and $1.6 million were related to incentive and retention programs.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE B—Adoption of New Accounting Standard

Effective as of the beginning of the Company’s fiscal 2003, the Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”). This new standard eliminates the amortization of goodwill and intangible assets with indefinite useful lives (collectively, the “Intangible Assets”). Instead these assets must be tested at least annually for impairment. In the year of adoption, FAS 142 also requires the Company to perform an initial assessment of its reporting units to determine whether there is any indication that the Intangible Assets carrying value may be impaired. This transitional assessment is made by comparing the fair value of each reporting unit, as determined in accordance with the new standard, to its book value. To the extent the fair value of any reporting unit is less than its book value, which would indicate that potential impairment of Intangible Assets exists, a second transitional test is required to determine the amount of impairment.

For purposes of Intangible Assets impairment testing, FAS 142 requires that goodwill be assigned to one or more reporting units. The Company has assigned goodwill to the Swift Denim and Galey & Lord Apparel reporting units. In addition to goodwill, Swift Denim also owns several trademarks whose useful lives are considered to be indefinite.

The Company, with the assistance of an outside consultant, completed the initial transitional assessment of its reporting units in the first quarter of fiscal 2003 and has determined that potential impairment of Intangible Assets exists in both reporting units. The Company expects to complete the second portion of the transitional test in the second quarter of fiscal 2003, which could result in an impairment writedown up to the remaining net book value of $111 million. Any impairment writedown resulting from the transitional testing will be reported as a cumulative effect of a change in accounting principle, retroactive to the first day of fiscal 2003. In future years, an impairment review of Intangible Assets will be conducted at least annually, and any impairment charges that are required to be recorded would be charged to operating income.

In addition, upon adoption of FAS 142, the Company ceased amortizing the remaining investment over its equity in the underlying net assets of its joint venture interests. However, equity method goodwill will continue to be reviewed in accordance with APB Opinion No. 18 “The Equity Method of Accounting for Investments in Common Stock.” The Company believes that no impairment of the equity method goodwill existed at December 28, 2002.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE B—Adoption of New Accounting Standard (Continued)

In accordance with FAS 142, prior period amounts were not restated. The following table adjusts the reported net loss for the three months ended December 29, 2001 and the loss per share amounts to exclude the amortization of Intangible Assets (in thousands, except per share data):

NOTE C—Basis of Presentation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Investments in affiliates in which the Company owns 20 to 50 percent of the voting stock are accounted for using the equity method. Intercompany items have been eliminated in consolidation.

Certain prior period amounts have been reclassified to conform to current year presentation.

The accompanying unaudited consolidated financial statements reflect all adjustments which are, in the opinion of management, necessary to present fairly the consolidated financial position of the Company as of December 28, 2002 and the consolidated results of operations and cash flows for the periods ended December 28, 2002 and December 29, 2001. Such adjustments consisted only of normal recurring items. Interim results are not necessarily indicative of results for a full year. These financial statements should be read in conjunction with the financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2002.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE D—Inventories

The components of inventory at December 28, 2002, December 29, 2001, and September 28, 2002 consisted of the following (in thousands):

On September 30, 2001, the Company changed its method of accounting for inventories to last-in, first-out (LIFO) for its Swift Denim business which was acquired on January 28, 1998. The Company believes that utilizing LIFO for the Swift Denim business will result in a better matching of costs with revenues and provide consistency in accounting for inventory among the Company’s North American operations. The Company also believes the utilization of LIFO is consistent with industry practice. Approximately $1.3 million of lower-of-cost-or-market (LCM) reserves were reversed in the quarter ended December 29, 2001 due to the change from FIFO to LIFO. In implementing the change in inventory method for Swift Denim, the opening fiscal 2002 inventory value under LIFO is the same as the year ending FIFO inventory value at September 29, 2001. The cumulative effect of implementing LIFO on prior periods and the pro forma effects of retroactive application is not determinable.

During the first quarter of fiscal 2002, the Company recorded a LIFO LCM charge of approximately $0.6 million, primarily in its Galey & Lord Apparel business. This LCM charge resulted from LIFO inventories carried at higher costs prevailing in prior years compared to current market values, the effect of which increased cost of sales and decreased net income.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE E—Long-Term Debt

Long-term debt consists of the following (in thousands):

Debtor-in-Possession Agreement

As discussed in Note A above, the Company and the Debtor subsidiaries entered into the DIP Financing Agreement pursuant to which the Company, as borrower, may make revolving credit borrowings (including up to $15 million for post-petition letters of credit) in an amount not exceeding the lesser of $100 million or the Borrowing Base (as defined in the DIP Financing Agreement). Effective September 24, 2002, the Company exercised its right, as permitted under the DIP Financing Agreement, to permanently reduce such maximum amount of revolving credit borrowings from $100 million to $75 million. See Note A above for a description of the DIP Financing Agreement.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE E—Long-Term Debt (Continued)

Pre-Petition Senior Credit Facility

On July 13, 1999, the Company amended its credit agreement, dated as of January 29, 1998 (the “Senior Credit Facility”), as amended, with First Union National Bank, as agent and lender and its syndicate of lenders. The amendment became effective as of July 3, 1999 (the “July 1999 Amendment”). In August 2001, the Company amended the Senior Credit Facility (the “August 2001 Amendment”) which, among other things, replaced the Adjusted Leverage Ratio covenant (as defined in the August 2001 Amendment) with a minimum EBITDA covenant (as defined in the August 2001 Amendment) until the Company’s December quarter 2002, waived compliance by the Company with the Adjusted Fixed Charge Coverage Ratio (as defined in the August 2001 Amendment) until the Company’s December quarter 2002 and modified the Company’s covenant related to capital expenditures. The August 2001 Amendment also excludes, for covenant purposes, charges related to closure of facilities announced on July 26, 2001. The August 2001 Amendment also increased the interest rate spread on all borrowings under the Company’s revolving line of credit and term loans by 100 basis points for the remainder of the term of its Senior Credit Facility. On January 24, 2002, the Company amended its Senior Credit Facility to provide for an overadvance of $10 million, none of which was drawn prior to the overadvance expiration on February 23, 2002.

Under the Senior Credit Facility, the Company is required to make mandatory prepayments of principal annually in an amount equal to 50% of Excess Cash Flow (as defined in the Senior Credit Facility), and also in the event of certain dispositions of assets or debt or equity issuances (all subject to certain exceptions) in an amount equal to 100% of the net proceeds received by the Company therefrom.

As a result of the February 2001 funding of the Company’s Canadian Loan Agreement (as defined below), the Company repaid $12.7 million in principal on its U.S. term loan balance and reduced the maximum amount of borrowings under its U.S. revolving line of credit by $12.3 million to $187.7 million. The repayment of the Term Loan B and Term Loan C principal balances ratably reduced the remaining quarterly principal payments. The reduction in the U.S. revolving line of credit facility resulted in a write-off of $0.1 million of deferred debt charges which is included in selling, general and administrative expenses in the March quarter 2001.

During the March quarter 2002, Klopman International used existing cash balances and borrowings under its credit agreements to complete a capital

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE E—Long-Term Debt (Continued)

reduction of $20.2 million with its European parent holding company (which is a wholly-owned subsidiary of the Company). In April 2002, $19.5 million was transferred from the Company’s European holding company to the Company in the United States. The Company then utilized the cash to repay its $7.4 million outstanding balance under its DIP Financing Agreement as well as repay $5.0 million, $4.2 million, and $2.9 million of the Company’s pre-petition revolving line of credit, Term Loan B, and Term Loan C borrowings, respectively, under the pre-petition Senior Credit Facility.

As a result of the Chapter 11 Filings, the Company and each of the Debtor subsidiaries are currently in default of the Senior Credit Facility. See Note A—Bankruptcy Filing.

Pre-Petition Senior Subordinated Debt

In February 1998, the Company closed its private offering of $300.0 million aggregate principal amount of 9 ¹/8% Senior Subordinated Notes Due 2008 (the “Notes”). In May 1998, the Notes were exchanged for freely transferable identical Notes registered under the Securities Act of 1933. Net proceeds from the offerings of $289.3 million (net of initial purchaser’s discount and offering expenses), were used to repay (i) $275.0 million principal amount of bridge financing borrowings incurred to partially finance the acquisition of the apparel fabrics business of Dominion Textile, Inc. on January 29, 1998 and (ii) a portion of the outstanding amount under a revolving line of credit provided for under the Senior Credit Facility (as defined herein). Interest on the Notes is payable on March 1 and September 1 of each year.

On August 18, 2000, the Company and its noteholders amended the indenture, dated February 24, 1998 (“the Indenture”), entered into in connection with the Notes to amend the definition of “Permitted Investment” in the Indenture to allow the Company and its Restricted Subsidiaries (as defined in the Indenture) to make additional investments (as defined in the Indenture) totaling $15 million at any time outstanding in one or more joint ventures which conduct manufacturing operations primarily in Mexico. This amendment was completed to allow the Company sufficient flexibility in structuring its investment in the Swift Denim-Hidalgo joint venture.

The Notes are general unsecured obligations of the Company, subordinated in right of payment to all existing and future senior indebtedness of the Company and its subsidiaries and senior in right of payment to any subordinated indebtedness of the Company. The Notes are unconditionally

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE E—Long-Term Debt (Continued)

guaranteed, on an unsecured senior subordinated basis, by Galey & Lord Industries, Inc., Swift Denim Services, Inc., G&L Service Company North America, Inc., Swift Textiles, Inc., Galey & Lord Properties, Inc., Swift Denim Properties, Inc. and other future direct and indirect domestic subsidiaries of the Company.

The Notes are subject to certain covenants, including, without limitation, those limiting the Company and its subsidiaries’ ability to incur indebtedness, pay dividends, incur liens, transfer or sell assets, enter into transactions with affiliates, issue or sell stock of restricted subsidiaries or merge or consolidate the Company or its restricted subsidiaries.

As a result of the Chapter 11 Filings, the Company and the Debtor subsidiaries are currently in default under the Notes and the Indenture. As of the Filing Date, the Company discontinued its interest accrual on the Notes and wrote off $7.7 million of deferred debt fees and the remaining discount on the Notes. See Note A—Bankruptcy Filing.

Italian Loan Agreements

The Company’s wholly owned Italian subsidiary, Klopman International S.r.l., had net borrowings of approximately $17.0 million outstanding under various unsecured bank line-of-credit agreements as of December 28, 2002. The average interest rate on these borrowings was 3.8% per annum during the December quarter 2002 and the various line-of-credit agreements renew automatically. The amount of outstanding credit allowed is subject to periodic review by the issuing banks. As of December 28, 2002, total unused credit under these agreements was approximately $35.0 million.

In addition, Klopman has an Italian government term loan of approximately $1.6 million. The term loan requires principal and interest payments through March 2011. The interest rate on such term loan is 4.11% per annum.

Canadian Loan Agreement

In February 2001, the Company’s wholly owned Canadian subsidiary, Drummondville Services Inc. (“Drummondville”), entered into a Loan Agreement (the “Canadian Loan Agreement”) with Congress Financial Corporation (Canada), as lender. The Canadian Loan Agreement provides for (i) a revolving line of credit under which Drummondville may borrow up to an amount equal to the lesser of U.S. $16.0 million or a borrowing base (comprised of eligible accounts receivable and eligible inventory of

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE E—Long-Term Debt (Continued)

Drummondville, as defined in the Canadian Loan Agreement), and (ii) a term loan in the principal amount of U.S. $9.0 million, which was originally borrowed and denominated in Canadian dollars.

Under the Canadian Loan Agreement, the revolving line of credit expires in February 2004 and the principal amount of the term loan is repayable in equal monthly installments of $229,500 CDN with the unpaid balance repayable in February 2004; provided, however, that the revolving line of credit and the maturity of the term loan may be extended at the option of Drummondville for up to two additional one year periods subject to and in accordance with the terms of the Canadian Loan Agreement. Effective July 24, 2002, the term loan was converted to U.S. dollars repayable in equal monthly installments of $150,000 U.S. dollars with the unpaid balance repayable in February 2004. Under the Canadian Loan Agreement, the interest rate on Drummondville’s borrowings initially is fixed through the second quarter of fiscal year 2001 (March quarter 2001) at a per annum rate, at Drummondville’s option, of either LIBOR plus 2.75% or the U.S. prime rate plus .75% (for borrowings in U.S. dollars) or the Canadian prime rate plus 1.5% (for borrowings in Canadian dollars). Thereafter, borrowings will bear interest at a per annum rate, at Drummondville’s option, of either (i) the U.S. prime rate plus 0%, .25%, .50%, .75%, or 1.0% (for borrowings in U.S. dollars), (ii) the Canadian prime rate plus .75%, 1.0%, 1.25%, 1.50%, or 1.75% (for borrowings in Canadian dollars), or (iii) LIBOR plus 2.00%, 2.25%, 2.50%, 2.75% or 3.00% (for borrowings in U.S. dollars ), all based on Drummondville maintaining certain quarterly excess borrowing availability levels under the revolving line of credit or Drummondville achieving certain fixed charge coverage ratio levels (as set forth in the Canadian Loan Agreement).

Drummondville’s obligations under the Canadian Loan Agreement are secured by all of the assets of Drummondville. The Canadian Loan Agreement contains certain covenants, including without limitation, those limiting Drummondville’s ability to incur indebtedness (other than incurring or paying certain intercompany indebtedness), incur liens, sell or acquire assets or businesses, pay dividends, make loans or advances or make certain investments. In addition, the Canadian Loan Agreement requires Drummondville to maintain a certain level of tangible net worth (as defined in the Canadian Loan Agreement). At December 28, 2002, the Company was in compliance with the covenants of the Canadian Loan Agreement.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE F—Net Income (Loss) Per Common Share

The following table sets forth the computation of basic and diluted earnings per share (in thousands):

Incremental shares for diluted earnings per share represent the dilutive effect of options outstanding during the quarter. Options to purchase 141,350 shares and 161,149 shares of common stock were outstanding during the three months ended December 28, 2002 and December 29, 2001, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares. Options to purchase 777,699 and 798,150 shares of common stock were outstanding during the three months ended December 28, 2002 and December 29, 2001, respectively, but were not included in the computation of diluted earnings per share pursuant to the contingent share provisions of Financial Accounting Standards Board Statement No. 128, “Earnings Per Share”. Vesting of these options is contingent upon the market price of common shares reaching certain target prices, which were greater than the average market price of the common shares.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE G—Benefit Plans

The Company and its U.S. subsidiaries sponsor noncontributory defined benefit pension plans covering substantially all domestic employees. The plans provide retirement benefits for all qualified salaried employees and qualified non-union wage employees based generally on years of service and average compensation. Retirement benefits for qualified union wage employees are based generally on a flat dollar amount for each year of service. The Company’s funding policy is to contribute annually the amount recommended by the plan’s actuary. Plan assets, which consist of common stocks, bonds and cash equivalents, are maintained in trust accounts.

On September 20, 2001, the Company froze the accrual of future retirement benefits under its U.S. defined benefit plans effective December 31, 2001. The resulting curtailment gain was offset by unamortized actuarial losses.

Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions,” (“FAS 87”) requires companies with any plans that have an unfunded accumulated benefit obligation to recognize an additional minimum pension liability, an intangible pension asset equal to the unrecognized prior service cost and if the additional liability required to recognized exceeds unrecognized service cost, the excess shall be reported in accumulated other comprehensive income (loss) as a separate component of equity. In accordance with FAS 87, the consolidated balance sheet at December 28, 2002 includes an intangible pension asset of $2.4 million, an additional minimum pension liability of $11.7 million and accumulated other comprehensive loss of $9.3 million.

The Company provides health care and life insurance benefits to certain retired employees and their dependents. The plans are unfunded and approved claims are paid by the Company. The Company’s cost is partially offset by retiree premium contributions. Effective December 31, 2001, the Company curtailed benefits to employees who were not retired as of December 31, 2001 and, accordingly, a net benefit curtailment gain of $3.4 million was recognized in the first quarter of fiscal 2002.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE H—Stockholders’ Equity (Deficit)

Comprehensive income (loss) represents the change in stockholders’ equity (deficit) during the period from non-owner sources. Currently, changes from non-owner sources consist of net income (loss), foreign currency translation adjustments, gains on derivative instruments and minimum pension liability. Total comprehensive income (loss) for the three months ended December 28, 2002 and December 29, 2001 was $3.5 million and $(8.0) million, respectively.

Activity in Stockholders’ Equity (Deficit) is as follows (in thousands):

Accumulated Other Comprehensive Income (Loss) at December 28, 2002 represents a $7.8 million loss related to foreign currency translation adjustment, a $9.3 million loss related to a minimum pension liability and $0.2 million gain related to derivative instruments.

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GALEY & LORD, INC.

(DEBTORS-IN-POSSESSION)

Notes to Consolidated Financial Statements

December 28, 2002

(Unaudited)

NOTE I—Income Taxes

The components of income tax expense (benefit) are as follows (in thousands):