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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the Fiscal Year ended December 31, 2002 or

For the Transition Period from                          to                         

Commission File Number: 000-23265

Salix Pharmaceuticals, Ltd.

(Exact name of Registrant as specified in its charter)

8540 Colonnade Center Drive, Suite 501  Raleigh, North Carolina 27615

(Address of principal executive offices, including zip code)

(919) 862-1000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act: None

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

Title of each class

Common Stock, $0.001 Par Value

Common Stock Purchase Rights

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

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

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

The aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant on June 30, 2002 (based on the closing sale price of US $15.26 of the Registrant’s common stock, as reported on The Nasdaq National Market on such date) was approximately U.S. $243,655,108. Common stock held by each officer and director and by each person known to the Company who owns 5% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares of the Registrant’s common stock outstanding at March 21, 2003 was 21,375,846.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement to be filed for its 2003 Annual Meeting of Stockholders currently scheduled to be held June 19, 2003 are incorporated by reference into Part III of this report.

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SALIX PHARMACEUTICALS, LTD.

ANNUAL REPORT ON FORM 10-K

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This report contains forward-looking statements within the meaning of Section 21e of the Securities Exchange Act of 1934. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated in these forward-looking statements as a result of certain factors, including those set forth under “Cautionary Statement” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report.

PART I

Item 1. Business

Our website address is www.salix.com. We make available free of charge through our website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

Overview

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to:

We rely on distribution relationships with third parties to sell our products outside the United States.

We in-licensed rights to balsalazide disodium from Biorex Laboratories Limited in 1992. In May 2000, we signed an agreement with Shire Pharmaceuticals Group plc under which Shire purchased from us the exclusive rights to balsalazide disodium for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, The Netherlands, Switzerland, Sweden and the United Kingdom. Under the agreement, Shire agreed to pay us up to a total of approximately $24 million in cash and Shire stock, including approximately $12.1 million in up-front fees and up to $12 million upon the achievement of milestones. In accordance with our license agreement with Biorex, we shared and will continue to share a portion of the cash payments with Biorex. In addition, we delivered all of the Shire stock we received to Biorex. In May 2000, Shire paid us $9.6 million of cash and $2.5 million by way of the issuance of 160,546 Shire shares. In August 2000, Shire paid us $4.4 million in connection with the transfer to Shire of the United Kingdom product license for balsalazide.

In July 2000, the United States Food and Drug Administration, or FDA, approved balsalazide disodium, which we sell in the United States under the brand name Colazal^® for marketing in the United States for the treatment of mildly to moderately active ulcerative colitis. In December 2000, we established our own 30-member, direct field sales force to market Colazal in the United States. This field sales force had over 60 members in the field as of December 31, 2002. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from balsalazide and rifaximin and other future products, if acquired and approved, will be more favorable to us than those from the indirect sale of product through marketing partners.

In 1996, we in-licensed rights to our second drug, rifaximin, in the United States and Canada from Alfa Wassermann. In December 2001, we submitted a New Drug Application, or NDA, to the FDA for rifaximin, as a treatment for travelers’ diarrhea. We received an approvable letter from the FDA in October 2002 and are in discussions with FDA regarding the requirements for an appropriate amendment to the NDA that would satisfactorily

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complete the approval process. If FDA approval is obtained, we intend to market rifaximin in the United States through our own direct sales force. We believe there are opportunities to develop rifaximin for other indications, including bacterial overgrowth in the small intestine, “c. difficile” and other forms of colitis, pouchitis, Crohn’s disease, and hepatic encephalopathy, and we intend to pursue these opportunities as we deem appropriate.

In July 2002, we in-licensed exclusive development and marketing rights in the United States to a granulated formulation of mesalamine from Dr. Falk Pharma. We intend to complete the development work required to secure regulatory approval for the product in the United States.

PRODUCTS

Colazal^® (balsalazide disodium)

Our first marketed product, Colazal, was the first new molecular entity approved in 10 years by the FDA for the treatment of mildly to moderately active ulcerative colitis and the first new oral therapy approved by the FDA for this indication in seven years. Ulcerative colitis is a chronic form of inflammatory bowel disease characterized by inflammation of the lining of the colon. Symptoms of active ulcerative colitis include rectal bleeding, abdominal pain, increased stool frequency, loss of appetite, fever and weight loss. This disease affects roughly 500,000 people in the United States, typically with onset under the age of 40. The cause of ulcerative colitis is unknown and no known cure exists except for the removal of the colon. Oral branded prescription products containing the active therapeutic agent 5-ASA are the first line of treatment and most frequently prescribed class of drugs for ulcerative colitis, with 2002 U.S. retail sales of approximately $430 million. In terms of prescription dollar sales, the market for 5-ASA products has been growing at an annual compound rate exceeding 25% for the last 11 years. Colazal contains 5-ASA, as does Asacol^®, the market-leading drug with retail sales of approximately $300 million in 2002.

In clinical trials, Colazal demonstrated at least comparable efficacy and had an improved safety profile as compared to some other oral 5-ASA products. Other 5-ASA products often do not deliver optimal doses of the active therapeutic agent to the colon. However, because Colazal’s proprietary formulation allows 99% of the drug to reach the colon, it can work more quickly and effectively than comparable doses of other 5-ASA products that deliver less drug to the diseased area. In addition, some other 5-ASA products have historically been associated with side effects that cause up to 15-40% of patients to discontinue treatment.

We launched Colazal in the United States in January 2001 using our own sales force. We sold $14.1 million of Colazal in the United States in the year ended December 31, 2001 and $33.5 million in the year ended December 31, 2002

Rifaximin

Our second drug, rifaximin, is an antibiotic that, if approved by the FDA, we intend to establish as the drug of choice for the treatment of travelers’ diarrhea and to investigate its use in a broad range of other gastrointestinal bacterial infections. According to the National Ambulatory Medical Care and National Hospital Ambulatory Medical Care surveys, between 1992 and 1996 (the most recent period for which we are aware there is publicly available information) patients visited physicians on average over 15 million times annually in the United States due to diarrhea, vomiting or gastrointestinal infections. According to the Centers for Disease Control, each year between 20% and 50% of international travelers, an estimated 10 million people, develop diarrhea, with approximately 80% of the cases caused by bacteria. Based upon recent data, between 4 million and 5 million people sought treatment in the United States for infectious diarrhea in 2001 and approximately 3.3 million of those patients were prescribed a drug.

We believe the advantages of rifaximin to treat these infections are four-fold: (1) site-targeted antibiotic delivery; (2) low systemic absorption; (3) activity against a variety of bacteria; and (4) improved tolerability compared to other treatments. Less than 0.1% of the drug is absorbed into the bloodstream when it is taken orally, which means that substantially all of the drug is available to destroy bacteria at the site of the infection. In addition, the drug might also cause fewer side effects or discomforts such as nausea, headache or dizziness than observed with currently available, more highly-absorbed antibiotics. Furthermore, we believe rifaximin is also less likely to cause systemic resistance, in which the body blocks the effectiveness of the drug, or harmful interaction with other drugs a patient is taking.

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We have completed two Phase III clinical studies of rifaximin for the treatment of travelers’ diarrhea. Data from these Phase III studies indicated that rifaximin is statistically more effective than placebo and that it had comparable efficacy and tolerability to ciprofloxacin, the market leader for the treatment of travelers’ diarrhea. We submitted an NDA for the treatment of travelers’ diarrhea to the FDA in December 2001. Based on a pre-submission review of portions of the NDA, the FDA indicated that additional clinical data would likely be necessary to gain approval for rifaximin. Accordingly, we commenced an additional clinical study in June 2002 to supplement the NDA. In October 2002, we received an approvable letter from the FDA. We are currently working to complete the ongoing clinical study and the FDA approval process.

We also intend to investigate the use of rifaximin in other indications, including bacterial overgrowth of the small intestine, c. difficile and other forms of colitis, pouchitis, Crohn’s disease, and hepatic encephalopathy. The FDA has granted rifaximin Orphan Drug status for the treatment of hepatic encephalopathy, which might allow for priority review and, if approved by the FDA, would provide for seven years of market exclusivity for this indication. Hepatic encephalopathy is a rare syndrome caused by a build-up of toxic products, such as ammonia, due to advanced liver disease.

Granulated Mesalamine

The next drug that we intend to develop is a granulated mesalamine product that is currently marketed in Germany by Dr. Falk Pharma under the trade name Salofalk^® Granu-Stix^® for the treatment of acute episodes and the maintenance of remission of ulcerative colitis. Salofalk Granu-Stix delivers the therapeutically active anti-inflammatory agent mesalamine (5-aminosalicylic acid or 5-ASA) to the distal ileum and colon by means of dual-release granules. We intend to complete the development work required to secure U.S. regulatory approval for the product, which is patent-protected until 2018. We believe the addition of this product to our portfolio will allow us to expand the range of treatment options for ulcerative colitis. The product’s prolonged release system is designed to consistently release mesalamine in the distal ileum and throughout the entire colon. Furthermore, the release characteristics of the product may present the possibility of less frequent dosing; therefore, we intend to explore the development of improved dosing regimens.

Strategic Alliances

We have and will continue to enter into various collaborations with corporate partners, licensors, licensees and others. To date, we have entered into the following strategic alliances:

Biorex Laboratories Limited

We in-licensed balsalazide, a new chemical entity, and all its salts, including our first marketed product, balsalazide disodium, from Biorex, a private, independent drug company headquartered in England. Biorex developed balsalazide and completed limited Phase III clinical trials. Under its agreements with us, Biorex will participate in future milestone revenues, royalties and profits from balsalazide.

Pursuant to an agreement entered into between us and Biorex in 1992, Biorex granted us the exclusive worldwide right (other than Japan, Taiwan, Korea and the United States) to develop, manufacture and sell balsalazide for all disease indications for a period of 15 years from the date of commercial launch, subject to early termination in certain circumstances, including upon the material breach by either party and, in the case of Biorex, in the event of our bankruptcy or if a sublicensee of ours terminates or becomes entitled to terminate its sublicense as a result of actions by us. Under a separate agreement, Biorex granted us the exclusive right to develop, manufacture and sell balsalazide for all disease indications in the United States for a period of nine years from the date of commercial launch or the term of the applicable patent, whichever is longer. Under these agreements, we paid Biorex fees upon entering into the agreements and are obligated to make additional milestone and royalty payments for the drug. The royalty payments to be made by us pursuant to the agreement governing the United States market are based on net sales, subject to minimum royalty payments for the first five years following commercial launch. Under the agreement governing territories other than the United States, we are obligated to pay to Biorex a portion of any gross profit on sales of balsalazide outside the United States. Under these agreements, we undertook to complete preclinical testing, perform clinical trials and obtain regulatory approvals

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for balsalazide. During 2001, we acquired from Biorex the exclusive right and license to develop, manufacture and sell balsalazide in Japan, Korea and Taiwan. There were no fees paid to Biorex upon entering into this agreement, but we are obligated to pay Biorex a portion of any gross profit on sales of balsalazide in Japan, Korea and Taiwan as well.

Alfa Wassermann S.P.A.

We in-licensed rifaximin from Alfa Wassermann, a privately held pharmaceutical company headquartered in Italy. Alfa Wassermann has developed several glycosaminoglycans, rifaximin and alpha-interferon from human leukocytes. Alfa Wassermann’s principal areas of therapeutic focus include anti-thrombotics, antibiotics, gastrointestinal products, NSAIDs, immunomodulators, anti-hypertensives and bronchopulmonary products.

Pursuant to our agreement, Alfa Wassermann granted us, in exchange for certain royalties, the exclusive right in the United States and Canada to develop, make, use and sell or have sold rifaximin for the treatment of gastrointestinal and respiratory tract diseases. Alfa Wassermann has agreed separately to supply the Company with bulk active ingredient rifaximin at a fixed price.

Pursuant to the license agreement, we agreed to pay Alfa Wassermann a net sales-based royalty, as well as certain milestone payments. Our obligation to pay royalties commences upon the commercial launch of the product and continues until the later of (1) the expiration of the period in which the manufacture, use or sale of the products by an unlicensed third party would constitute an infringement on the patent covering the product or (2) 10 years from commercial launch. Thereafter, the licenses granted to us shall continue as irrevocable royalty-free paid-up licenses.

The license agreement does not have a set term and continues until terminated in accordance with its terms. Either party to the agreement may terminate it following a material breach by the other party and the failure of the breaching party to remedy the breach within 60 days. In addition, Alfa Wassermann has the right to terminate the agreement on three months’ written notice in the event that we fail to use best efforts to develop the product in a timely manner, fail to effect commercial launch within six months of receipt of regulatory approval or fail to sell the product for a period of six consecutive months after commercial launch. In addition, Alfa Wassermann may terminate the agreement if we become involved in bankruptcy, liquidation or similar proceedings. We may terminate the agreement in respect of any indication or any part of the territory covered on 90 days’ notice, at which point our rights with respect to that indication or territory shall cease.

Menarini Pharmaceutical Industries S.R.L.

Menarini, headquartered in Italy, is the largest manufacturer and distributor of pharmaceuticals in Southern Europe. Menarini also has extensive experience developing and marketing therapies for gastrointestinal disease in its markets. Under our agreements with Menarini, we granted Menarini certain manufacturing rights and exclusive distribution rights with respect to balsalazide in Italy, Spain, Portugal and Greece. Through December 31, 2001, we had received revenues as partial contribution to research and development costs borne by us of approximately $1.2 million. The agreement calls for additional milestone revenues to be paid to us relating to European marketing approvals in the Menarini territories. During 2001, Menarini paid a $270,000 milestone payment to us related to receipt of marketing approval in Italy. The funding provided through this alliance allowed us to partially fund the development of balsalazide. Under the terms of the agreements, we will sell the bulk active ingredient balsalazide to Menarini for marketing and distribution in its territories at cost plus a sales-based royalty. During 2001, Menarini paid us approximately $1.2 million for bulk active ingredient balsalazide. Menarini did not purchase any bulk active ingredient balsalazide from us during 2002.

Unless terminated sooner in accordance with its terms, the agreement with Menarini continues until the earlier of the expiration of (1) the patents relating to the product or (2) 15 years from the date of the agreement, provided however that in any case the agreement shall continue for a period of 10 years from the date of first launch. Either party may terminate the agreement upon a material breach by the other party and the failure to remedy such breach within 30 days in the case of a payment breach or 90 days in the case of any other material breach or if a party enters liquidation, bankruptcy or similar proceedings.

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Shire Pharmaceuticals Group plc

In May 2000, we signed an agreement with Shire Pharmaceuticals Group under which Shire purchased from us the exclusive rights to balsalazide, for use as a treatment for ulcerative colitis for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, The Netherlands, Switzerland, Sweden and the United Kingdom. Under the agreement, Shire agreed to pay us up to a total of approximately $24.0 million, including approximately $12.1 million in up-front fees and up to $12.0 million upon the achievement of certain milestones. In accordance with our license arrangement with Biorex Laboratories Limited, its licensor, we shared a portion of these payments, including all of the Shire ordinary shares, with Biorex. In May 2000, Shire paid us $9.6 million of cash and $2.5 million by way of the issue of 160,546 new Shire ordinary shares. In August 2000 Shire paid us $4.4 million in connection with the transfer to Shire of the United Kingdom product license for balsalazide. No additional payments were made to us by Shire in 2001 or 2002.

Dr. Falk Pharma GmbH

In July 2002, we in-licensed rights to a granulated formulation of mesalamine under an agreement with Dr. Falk Pharma of Freiburg, Germany. The agreement gives us the exclusive rights to develop and market the product in the United States. In return we will make upfront, milestone and royalty payments to Falk. The agreement also provides us a right of first negotiation with respect to rights to develop and market certain additional Falk products in the United States.

Manufacturing

We own no manufacturing facilities. We have in the past used and will continue to use third-party manufacturers to produce material for use in clinical trials and for commercial product. This manufacturing strategy enables us to direct our financial resources to product in-licensing and acquisition, product development, and sales and marketing efforts, without devoting resources to the time and cost associated with building large manufacturing plants.

Currently, we are using active pharmaceutical ingredient balsalazide manufactured for us by Omnichem s.a., a subsidiary of Ajinomoto in Belgium. Balsalazide is being encapsulated for us by Anabolic in Irvine, California. In addition, we are in the process of qualifying an additional manufacturer of commercial quantities of the active pharmaceutical ingredient balsalazide and are in negotiations to secure an additional encapsulator.

Under our supply agreement with Alfa Wasserman, Alfa Wassermann is obligated to supply us with bulk active ingredient rifaximin. Currently, Alfa Wassermann manufactures rifaximin for the Italian and other European markets. We are in negotiations to secure additional sources of commercial quantities of the pharmaceutical ingredient rifaximin and to secure an additional manufacturer of drug product.

With respect to the granulated mesalamine product, we are in negotiations to secure a source of bulk active ingredient and a manufacturer of drug product.

Sales and Marketing

We currently market Colazal and intend, if approved by the FDA, to market rifaximin and other future products to U.S. gastroenterologists through our own direct sales force, and enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate. In connection with our commercial launch of Colazal, we hired approximately 30 field sales representatives in late 2000. To more effectively cover the gastroenterology market, we expanded our field sales force to over 60 people during 2001. We believe our sales force should also position us to sell additional products, including the granulated mesalamine product. To that end, our specialty sales force recently began promoting Donnatal Extentabs^® to gastroenterologists. Donnatal is a belladonna/alkaloid/phenobarbital class product used as adjunctive therapy in the treatment of irritable bowel syndrome, or IBS. We have entered into a short-term agreement with PBM Pharmaceuticals to detail the product on a fee per call basis. Donnatal Extentabs provides not only an opportunity for us to leverage our sales force prior to the launch of rifaximin, but also provides an opportunity for us to train our sales force in another important therapeutic area of gastroenterology. We do not expect revenue from this short-term agreement to have a material impact on the Company’s results of operations.

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PATENTS AND PROPRIETARY RIGHTS

General

The patents for the balsalazide composition of matter and method of treating ulcerative colitis with balsalazide expired in July 2001 in the United States. We have obtained patent extensions for the composition of balsalazide in Italy and the United Kingdom until July 2006. The patents for the rifaximin composition of matter (also covering a process of making rifaximin and using rifaximin to treat gastrointestinal infectious diseases) expired in May 2001 in the United States and Canada. We have filed applications for patents for additional indications using balsalazide and related chemical substances. The patent for the treatment of the intestinal tract with the granulated mesalamine product will expire in 2018.

Patent Term Extensions and Data Exclusivity

We believe we may be eligible for additional extensions of our patents relating to balsalazide of up to five years (including extensions of our patents that would have expired during regulatory review) based on patent term restoration procedures established in Europe and in the United States under the Waxman-Hatch Act for products that have received regulatory approval. Under the Waxman-Hatch Act, the United States Patent and Trademark Office is directed to extend the term of an eligible patent for a time equal to the regulatory review period for the approved product. This time period is generally one-half the length of time between the effective date of the IND and submission of the NDA, plus the length of time between filing and approval of the NDA up to a total possible extension of five years. Periods during which the applicant did not act with due diligence may be subtracted from the regulatory review period.

We have filed a patent term extension under Waxman-Hatch by which the balsalazide patent in the United States could be extended by up to five years, giving patent protection until as late as July 2006.

In 2000, the FDA granted us five years of new chemical entity data exclusivity for balsalazide. This means that for five years from the date of approval of our NDA for balsalazide, the FDA will not approve an application for a competitive version of balsalazide which relies upon data included in our NDA. Therefore, unless an applicant for a competitive version of balsalazide were to develop its own data supporting approval of its NDA, this data exclusivity will have the effect of preventing generic competition for balsalazide until at least July 2005.

Because rifaximin is a new chemical entity, we also expect to obtain similar 5 year exclusivity for it if approved.

Although the granulated mesalamine product is not a new chemical entity, it may be entitled to three years of exclusivity from the date of its approval if new clinical investigations are required for its approval. Such exclusivity would have the effect of preventing the FDA from approving an NDA for a granulated mesalamine product which relied upon the new clinical investigation in our NDA for three years from the date of approval.

Government Regulation

The research, testing, manufacture, marketing and distribution of drug products are extensively regulated by governmental authorities in the United States and other countries. In the United States, drugs are subject to rigorous regulation by the FDA. The Federal Food, Drug and Cosmetic Act, as amended, and the regulations promulgated thereunder, and other federal and state statutes and regulations, govern, among other things, the research, development, testing, manufacture, storage, record keeping, labeling, promotion and marketing and distribution of pharmaceutical products. Failure to comply with applicable regulatory requirements may subject a company to administrative sanctions or judicially imposed sanctions such as civil penalties, criminal prosecution, injunctions, product seizure or detention, product recalls, and total or partial suspension of product marketing and/or approvals. In addition, non-compliance may result in the FDA’s refusal to approve pending NDAs or supplements to approved NDAs or in the withdrawal of an NDA. Any such sanction could result in adverse publicity, which could have a material adverse effect on our business, financial conditions, and results of operation.

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The steps ordinarily required before a new pharmaceutical product containing a new chemical entity may be marketed in the United States include: (1) preclinical laboratory tests, preclinical studies in animals and formulation studies; (2) the submission to the FDA of a notice of claimed investigational exemption for a new drug or antibiotic, which must become effective before clinical testing may commence; (3) adequate and well-controlled clinical human trials to establish the safety and efficacy of the drug for each indication; (4) the submission of an NDA to the FDA; and (5) FDA review and approval of the NDA prior to any commercial sale or shipment of the drug. Preclinical tests include laboratory evaluation of product chemistry and formulation, as well as animal studies to assess the potential safety and efficacy of the product. Preclinical tests must be conducted in compliance with Good Laboratory Practice regulations. The results of preclinical testing are submitted to the FDA as part of an IND. A 30-day waiting period after the filing of each IND is required prior to the commencement of clinical testing in humans. In addition, the FDA may, at any time during this 30-day period or at any time thereafter, impose a clinical hold on proposed or ongoing clinical trials. If the FDA imposes a clinical hold, clinical trials cannot commence or recommence without FDA authorization and then only under terms authorized by the FDA. In some instances, the IND application process can result in substantial delay and expense.

Clinical trials to support NDAs are typically conducted in three sequential phases, but the phases may overlap. In Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses. Phase II usually involves studies in a limited patient population to (1) assess the efficacy of the drug in specific, targeted indications, (2) assess dosage tolerance and optimal dosage and (3) identify possible adverse effects and safety risks. If a compound is found to be potentially effective and to have an acceptable safety profile in Phase II evaluations, Phase III trials are undertaken to further demonstrate clinical efficacy and to further test for safety within an expanded patient population at geographically dispersed clinical study sites. There can be no assurance that Phase I, Phase II or Phase III testing will be completed successfully within any specified time period, if at all, with respect to any of our products subject to such testing.

After successful completion of the required clinical testing, generally an NDA is submitted. FDA approval of the NDA is required before marketing may begin in the United States. The FDA reviews all NDAs submitted before it accepts them for filing and may request additional information rather than accepting an NDA for filing. In such an event, the NDA must be resubmitted with the additional information and, again, is subject to review before filing. Once the submission is accepted for filing, the FDA begins an in-depth review of the NDA. The FDA has 10 months in which to review the NDA and respond to the applicant. The review process is often significantly extended by FDA requests for additional information or clarification regarding information already provided in the submission. The FDA may refer the application to an appropriate advisory committee, typically a panel of clinicians, for review, evaluation and a recommendation as to whether the application should be approved. The FDA is not bound by the recommendation of an advisory committee. If FDA evaluations of the NDA and the manufacturing facilities are favorable, the FDA may issue either an approval letter or an approvable letter, which usually contains a number of conditions that must be met in order to secure final approval of the NDA. When and if those conditions have been met to the FDA’s satisfaction, the FDA will issue an approval letter, authorizing commercial marketing of the drug for certain indications. If the FDA’s evaluation of the NDA submission or manufacturing facilities is not favorable, the FDA may refuse to approve the NDA or issue a not approvable letter, outlining the deficiencies in the submission and often requiring additional testing or information. If regulatory approval of any product is granted, such approval will be limited to those disease states and conditions for which the product has been found by the FDA to be safe and effective, as demonstrated through well controlled clinical studies. Furthermore, approval may entail ongoing requirements for post-marketing studies. Even if such regulatory approval is obtained, a marketed product, its manufacturer and its manufacturing facilities are subject to continual review and periodic inspections. In addition, identification of certain side effects after a drug is on the market or the occurrence of manufacturing problems could cause subsequent withdrawal of approval, reformulation of the drug, additional preclinical testing or clinical trials and changes in labeling of the product.

Under the Orphan Drug Act, the FDA may designate a product as an orphan drug if it is a drug intended to treat a “rare disease or condition,” which is a disease or condition that affects populations of fewer than 200,000 individuals in the United States or a disease whose incidence rates number more than 200,000 where the sponsor establishes that it does not realistically anticipate that its product sales will be sufficient to recover its costs. The sponsor that obtains the

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first marketing approval for a designated orphan drug for a given rare disease is eligible to receive marketing exclusivity for use of that drug for the orphan indication for a period of seven years.

Drug manufacturing establishments are subject to periodic inspection by regulatory authorities and must comply with Good Manufacturing Practice regulations. Either we or our third party manufacturer must pass a preapproval inspection of our respective manufacturing facilities by the FDA before obtaining marketing approval of any products for sale in the United States. These manufacturers are also subject to periodic FDA inspections. In the event that violations of applicable standards are found, we may be required to cease distribution of some or all products and may be required to recall products already distributed.

Regulation of Drug Compounds Outside of the United States

Outside the United States, the ability to market a drug is contingent upon receiving marketing authorizations from the appropriate regulatory authorities. The requirements governing the conduct of clinical trials and marketing authorization vary widely from country to country. Currently, foreign marketing authorizations are applied for at a national level, although within the European Union procedures are available to companies wishing to market a product in more than one European Union member state. The foreign regulatory approval process includes all of the risks associated with FDA approval set forth above.

To market our products in Europe, we or our distributors also must satisfy foreign regulatory requirements, implemented by foreign health authorities, governing human clinical trials and marketing approval. In the United Kingdom, the sale and marketing of new drugs is subject to the approval of the Medicines Control Agency, or MCA. As in the United States, a company seeking regulatory approval must submit an application requesting such approval, which is referred to as a Product License Application, or PLA. The PLA is submitted after completion of pre-clinical and clinical studies. The MCA may request additional clinical information on efficacy or safety before formally reviewing the application. Following a review of the PLA, the MCA makes a determination as to approval of the new drug compound. The review process in the United Kingdom is subject to many of the same uncertainties and risks associated with the approval of new drugs by the FDA in the United States. Furthermore, approval may entail ongoing requirements for post-marketing studies. Even if such regulatory approval is obtained, a marketed product and its manufacturer and its manufacturing facilities are subject to continual review and periodic inspections by the MCA.

Under a relatively new regulatory system in Europe, marketing authorizations, broadly speaking, may be submitted at a centralized, a decentralized or a national level. The centralized procedure is mandatory for the approval of biotechnology and high technology products and available at the applicant’s option for other products. The centralized procedure provides for the first time in the European Union for the grant of a single marketing authorization which is valid in all EU member states. Alternatively, a mutual recognition procedure implemented in January 1995 is available at the request of the applicant for all medicinal products that are not subject to the centralized procedure under the so-called “decentralized procedure”. The decentralized procedure, which began in January 1998, created a new system for mutual recognition of national approval decisions, made changes to then existing procedures for national approvals and established procedures for coordinated EU actions on products, suspensions and withdrawals.

If and when necessary, we will choose the appropriate route of European regulatory filing to accomplish the most rapid regulatory approvals. However, the chosen regulatory strategy might not secure regulatory approvals or approvals of our chosen product indications. Furthermore, we must obtain pricing approval in addition to regulatory approval prior to launching the product in the approving country. Failure to obtain pricing approval in a timely manner or approval of pricing which would support an adequate return on investment or generate a sufficient margin to justify the economic risk might delay or prohibit the commercial launch of the product in those countries.

Competition

Competition in our business is intense and characterized by extensive research efforts and rapid technological progress.

Technological developments by competitors, earlier regulatory approval for marketing competitive products, or superior marketing capabilities possessed by competitors could adversely affect the commercial potential of our products and could have a material adverse effect on our revenue and results of operations. We believe that there are

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numerous pharmaceutical and biotechnology companies, including large well-known pharmaceutical companies, as well as academic research groups throughout the world, engaged in research and development efforts with respect to pharmaceutical products targeted at gastrointestinal diseases and conditions addressed by our current and potential products. In particular, we are aware of products in research or development by competitors that address the diseases being targeted by our products. Developments by others might render our current and potential products obsolete or non-competitive. Competitors might be able to complete the development and regulatory approval process sooner and, therefore, market their products earlier than us. Many of our competitors have substantially greater financial, marketing and personnel resources and development capabilities than we do. For example, many large, well capitalized companies already offer products in the United States and Europe that target the indications for balsalazide and the granulated mesalamine product, including mesalamine (GlaxoSmithKline plc, Giuliani S.p.A., Axcan Pharma, Inc., Solvay S.A., The Procter & Gamble Company, Shire Pharmaceuticals Group plc, and Ferring Pharmaceuticals), sulfasalazine (Pharmacia & Upjohn, Inc.), and olsalazine (Celltech Group). Asacol, marketed by Proctor & Gamble, is currently the most prescribed product for the treatment of ulcerative colitis in the United States. The most frequently prescribed product for treatment of travelers’ diarrhea in the United States currently is ciprofloxacin, commonly known as “Cipro^®“ and marketed by Bayer AG.

Employees

As of December 31, 2002, we had 135 full-time employees. We believe that our future success will depend in part on our continued ability to attract, hire, and retain qualified personnel. Competition for such personnel is intense, and there can be no assurance that we will be able to identify, attract, and retain such personnel in the future. None of our employees are represented by a labor union. We have not experienced any work stoppages and consider our relations with our employees to be good.

Item 2. Properties

Our corporate headquarters are located at 8540 Colonnade Center Drive, Suite 501, Raleigh, North Carolina 27615, where we occupy approximately 26,000 square feet of office space under a lease extending through August 31, 2011. We have additional space in Palo Alto, California, where we occupy approximately 3,000 square feet under a lease through February 28, 2004.

Item 3. Legal Proceedings

From time to time, we are party to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. Management has reviewed pending legal matters and believes that the resolution of such matters will not have a significant adverse effect on our financial condition or results of operations.

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

No matter was submitted to a vote of our stockholders during the fourth quarter of the year ended December 31, 2002.

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Executive Officers of the Registrant

The following table sets forth certain information concerning our executive officers as of December 31, 2002:

Robert P. Ruscher joined Salix in April 1995 and has served as the Executive Chairman of the Board since July 2002 and as a member of the Board of Directors since November 1999. Prior to assuming his current position, Mr. Ruscher held various positions of increasing responsibilities within Salix, including President and Chief Executive Officer, Executive Vice President, Vice President of Business Development, Chief Financial Officer and Corporate Secretary. Before joining Salix, Mr. Ruscher practiced law, advising emerging growth pharmaceutical companies in licensing, corporate partnering, financing and general corporate matters with Wyrick Robbins Yates & Ponton from May 1994 to April 1995; with Venture Law Group, which he co-founded, from March 1993 to April 1994; and with Wilson Sonsini Goodrich & Rosati from June 1988 to February 1993. From July 1983 to July 1986, Mr. Ruscher was a Senior Accountant with Price Waterhouse in San Francisco, California, working with emerging growth technology companies. Mr. Ruscher is a Certified Public Accountant and received his J.D. with distinction from the Stanford University School of Law and his B.S. in Commerce (Business Administration) with distinction from the University of Virginia.

Carolyn J. Logan has served as President and Chief Executive Officer and as a member of the Board of Directors since July 2002. She previously served as Senior Vice President, Sales and Marketing from June 2000 to July 2002. Prior to joining Salix, Ms. Logan served as Vice President, Sales and Marketing of the Oclassen Dermatologics division of Watson Pharmaceuticals, Inc. from May 1997 to June 2000, and as Vice President, Sales from February 1997 to May 1997. Prior to that date, she served as Director, Sales of Oclassen Pharmaceuticals, Inc. from January 1993 to February 1997. Prior to joining Oclassen, Ms. Logan held various sales and marketing positions with Galderma Laboratories, Ulmer Pharmacal and Westwood Pharmaceuticals. Ms. Logan received a B.S. degree in Biology and Dental Hygiene from the University of North Carolina at Chapel Hill.

Adam C. Derbyshire has served as Vice President, Finance and Administration and Chief Financial Officer since June 2000. Prior to joining Salix, Mr. Derbyshire was Vice President, Corporate Controller and Secretary of Medco Research, Inc. (acquired by King Pharmaceuticals, Inc. in February 2000) from June 1999 to June 2000, Corporate Controller and Secretary of Medco from September 1995 to June 1999 and Assistant Controller of Medco from October 1993 to September 1995. Mr. Derbyshire received his B.S. degree from the University of North Carolina at Wilmington and his MBA from the University of North Carolina at Charlotte.

Randy W. Hamilton is one of the co-founders of Salix and was Chairman of the Board from inception until July 2002. From inception through November 1999 he was also President and Chief Executive Officer. Prior to founding Salix, Mr. Hamilton was Business Development Manager for California Biotechnology, Inc., now Scios, Inc., responsible for licensing products to the Japanese pharmaceutical industry and for the commercial aspects of several of the company’s development projects, including human lung surfactant, nasal drug delivery systems, genetic market diagnosis, and growth factors. Before joining California Biotechnology, Inc., Mr. Hamilton was Director of Strategic Planning and Business Development for SmithKline Diagnostics, then a division of SmithKline Beecham, where he also held positions in market research and marketing information services. Mr. Hamilton received his B.A. in Sociology from California State University, Long Beach.

R. Scott Sykes, M.D. joined Salix in September 2001 with 18 years of industry experience. He is responsible for all medical affairs, including drug information services, product safety, and post-marketing surveillance. Dr. Sykes was previously employed by GlaxoSmithKline, where he served most recently as Vice President, North American Product Surveillance. Dr. Sykes holds an M.D. from the University of North Carolina School of Medicine.

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PART II

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

Our common stock is traded on the Nasdaq National Market under the symbol “SLXP.” The following table sets forth the high and low sales prices of our common stock, as reported on the Nasdaq SmallCap Market until February 26, 2001, and on the Nasdaq National Market starting then.

On December 31, 2002, the closing price for the common stock as reported on the Nasdaq National Market was $6.99. As of March 21, 2003, there were approximately 3,000 stockholders of record.

The securities markets have from time to time experienced significant price and volume fluctuations unrelated to the operating performance of particular companies. In addition, the market prices of the common stock of many publicly traded pharmaceutical and biotechnology companies have in the past and can in the future be expected to be especially volatile. Announcements of technological innovations or new products by us or our competitors, developments or disputes concerning proprietary rights, publicity regarding actual or potential medical results relating to products under development by us or our competitors, regulatory developments in both the United States and other countries, public concern as to the safety of pharmaceutical products and economic and other external factors, as well as period-to-period fluctuations in our financial results, might have a significant impact on the market price of our common stock.

Dividend Policy

We have never declared or paid cash dividends on our common stock. Under the terms of our line of credit agreement with RBC Centura, the Company is prohibited from paying a dividend on its stock without RBC Centura’s consent. We currently expect to retain future earnings, if any, for use in the operation and expansion of business and do not anticipate paying any cash dividends in the foreseeable future.

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Item 6. Selected Consolidated Financial Data

The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and the Notes thereto included elsewhere in this report. The following selected financial data are derived from the consolidated financial statements of Salix Pharmaceuticals, Ltd. which have been audited by Ernst & Young LLP, independent auditors. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein.

Consolidated Statement of Operations Data:

Consolidated Balance Sheet Data:

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

Overview

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved; apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and use our over 60-person sales force focused on high-prescribing U.S. gastroenterologists to sell our products. We rely on distribution relationships with third parties to sell our products outside the United States.

We in-licensed rights to balsalazide disodium from Biorex Laboratories Limited in 1992. In May 2000, we signed an agreement with Shire Pharmaceuticals Group plc under which Shire purchased from us the exclusive rights to balsalazide disodium for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, The Netherlands, Switzerland, Sweden and the United Kingdom. Under the agreement, Shire agreed to pay us up to a total of approximately $24 million in cash and Shire stock, including approximately $12.1 million in up-front fees and up to $12 million upon the achievement of milestones. In accordance with our license agreement with Biorex, we shared and will continue to share a portion of the cash payments with Biorex. In addition, we delivered all of the Shire stock we received to Biorex. In May 2000, Shire paid us $9.6 million of cash and $2.5 million by way of the issuance of 160,546 Shire shares. In August 2000, Shire paid us $4.4 million in connection with the transfer to Shire of the United Kingdom product license for balsalazide.

In July 2000, the FDA approved Colazal for marketing in the United States for the treatment of mildly to moderately active ulcerative colitis. In December 2000, we established our own 30-member, direct sales force to market Colazal in the United States. This sales force had over 60 members in the field as of December 31, 2002. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from balsalazide and rifaximin and other future products, if acquired and approved, will be more favorable to us than those from the indirect sale of product through marketing partners.

In 1996, we in-licensed rights to our second drug, rifaximin, in the United States and Canada from Alfa Wassermann. In December 2001, we submitted an NDA to the FDA for rifaximin, as a treatment for travelers’ diarrhea. We received an approvable letter from the FDA in October 2002 and are currently working with the FDA to submit an amendment to the NDA and complete the approval process. We believe there are opportunities to develop rifaximin for other indications, including bacterial overgrowth in the small intestine, “c. difficile” and other forms of colitis, pouchitis, Crohn’s disease, and hepatic encephalopathy, and we intend to pursue these opportunities, as we deem appropriate. If FDA approval is obtained, we intend to market rifaximin in the United States through our own direct sales force.

In July 2002, we in-licensed exclusive development and marketing rights in the United States to a granulated formulation of mesalamine from Dr. Falk Pharma. We intend to complete the development work required to secure regulatory approval for the product in the United States.

In November 2000, we raised approximately $13.1 million, net of offering expenses, through a private placement of 2.26 million shares of common stock. In May 2001, we raised approximately $28.1 million, net of offering expenses, through a private placement of 1.96 million shares of common stock. In March 2002, we raised approximately $57.4 million, net of offering expenses, through the public offering of 4.6 million shares of our common stock.

On December 31, 2001, we changed our place of incorporation from the British Virgin Islands to the state of Delaware.

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CRITICAL ACCOUNTING POLICIES

General

Salix Pharmaceuticals’ discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, Salix Pharmaceuticals evaluates its estimates, including those related to sales of its products, bad debts, inventories, investments, intangible assets, and legal issues. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results might differ from these estimates under different assumptions or conditions.

Methodologies used and assumptions selected by management in making these estimates, as well as the related disclosures, have been reviewed by and discussed with the Company’s Audit Committee.

Salix Pharmaceuticals believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition

Product sales are recorded upon shipment of order and transfer of title. In December 2000, we made our first U.S. sales of Colazal to wholesalers.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101, (“SAB 101”) “Revenue Recognition in Financial Statements,” that, among other guidance, clarifies certain conditions to be met in order to recognize revenue. SAB 101 requires companies to recognize up-front non-refundable fees over the term of the related agreement unless the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. In the fourth quarter of 2000, we implemented SAB 101, which had no impact on prior years but did affect 2000. Accordingly, there was no cumulative effect of the adoption of SAB 101 as of January 1, 2000. However, as a result of the adoption of SAB 101, $8.7 million of the $11.7 million initial payment received from Shire and previously recognized as revenue during the second quarter of 2000 was deferred and was recognized as revenue ratably through the end of 2001. The other $3.0 million received from Shire was initially deferred and will continue to be recognized according to contract terms, for any future clinical studies for balsalazide conducted in order to gain approval in France, The Netherlands and Germany.

Due to the uniqueness of each of our licensing arrangements, we analyze each element of each contract, including milestone payments, to determine the appropriate revenue recognition. In accordance with SAB 101, we recognize revenue upon achievement of contractual milestones only when and to the extent we conclude that a separate earnings process has been culminated or the milestone is representative of the level of effort and progress toward completion of a long-term contract.

Investments

We consider all investments that have a maturity of greater than three months and less than one year to be short-term investments. All securities with maturities beyond one year are considered long-term investments. Our short-term and long-term investments consist of government agency and high-grade corporate bonds. The Company has the intent and ability to hold these investments until maturity; therefore, the investments are classified as held-to-maturity and are reported at amortized cost.

Inventories

As of December 31, 2002, the Company had $10.2 million in inventories. Inventories of pharmaceutical products were comprised of $7.3 million of raw materials and $2.9 million of finished goods. As of December 31, 2002, the Company has approximately $2.2 million in inventories relating to a product that has not received final approval by the FDA. Inventories are stated at the lower of cost (which approximates actual cost on a first-in, first-out cost method) or market. In evaluating whether inventory is stated at the lower of cost or market, management considers such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell such inventory, remaining shelf life and current and expected market conditions, including levels of competition. As appropriate, provisions are made to reduce inventories to their net realizable value.

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Allowance for Uncollectible Accounts

To date, we have not experienced any material accounts receivable collection issues. However, based on a review of specific customer balances, industry experience and the current economic environment, we currently reserve 1% of our outstanding trade accounts receivable balance as an allowance for uncollectible accounts, which at December 31, 2002 and December 31, 2001was approximately $60,500 and $14,000, respectively.

Allowance for Rebates and Coupons

Based on current contracts that allow for rebates and our estimate of revenue associated with those contracts, we currently reserve an allowance for rebate charges based on each individual contract, which at December 31, 2002 and December 31, 2001 was $0.6 million and $0.7 million, respectively. Based on the number of available coupons, our estimate of redemption of available coupons from industry experience, we reserved approximately $25,000 and $0.5 million as an allowance for coupon redemption at December 31, 2002 and December 31, 2001 respectively.

Results of Operations

Years Ended December 31, 2002, 2001 and 2000

Revenues totaled $33.5 million, $22.4 million and $14.5 million for 2002, 2001 and 2000, respectively. Revenues for the year ended December 31, 2002 consisted solely of product revenues of $33.5 million. Revenues for the year ended December 31, 2001 included product revenues of $14.1 million and revenues from collaborative agreements of $8.3 million, of which $5.5 million related to the agreement with Shire. Revenues for the year ended December 31, 2000 included product revenues of $6.3 million and revenues from collaborative agreements of $8.2 million, of which $7.6 million related to the agreement with Shire. We expect that future revenues will consist solely or primarily of product revenue.

Product revenues during 2002 were higher than in 2001 due to increased sales of Colazal. Product revenues during 2001 were higher than in 2000 due to the U.S. launch of Colazal in January 2001. Product revenues in 2000 were recorded net of credits to AstraZeneca for past research and development funding equal to 20% of invoiced sales.

Total costs and expenses were $59.3 million, $40.4 million and $17.7 million for 2002, 2001 and 2000, respectively. The increase in 2002 was primarily the result of increased sales of Colazal. The substantial increase in 2001 was the result of the U.S. launch of Colazal in January 2001 and increased expenditures associated with expanding our commercialization infrastructure.

We recognized cost of products sold of $8.2 million, $3.5 million and $2.3 million for 2002, 2001 and 2000, respectively. The increase in cost of products sold in 2002 was due primarily to increased sales of Colazal. The increase in cost of products sold in 2001 was due to the U.S. launch of Colazal in January 2001. License fees and costs related to collaborative agreements of $0.1 million, $5.6 million and $4.2 million in 2002, 2001 and 2000, respectively, related primarily to payments made to Biorex and Alfa Wassermann under the terms of the respective license agreements. The decrease in licensee fees and costs related to collaborative agreements in 2002 from 2001 was due to the completion in 2001 of the amortization of upfront payments related to the Shire Agreement. The increase in license fees and costs related to collaborative agreements in 2001 from 2000 was due to payments to Biorex, the licensor of balsalazide disodium, as a result of the Shire Agreement and expenses related to supplying balsalazide to Menarini and Shire.

Research and development expense was $18.0 million, $6.6 million and $3.8 million for 2002, 2001 and 2000, respectively. The increase in research and development expenses in 2002 from 2001 was due primarily to costs associated with maintaining the NDA and initiating a study to support the NDA for rifaximin as a treatment for travelers’ diarrhea, as well as, the ongoing multi-center study for rifaximin as a treatment for hepatic encephalopathy, the single-center study for rifaximin as a treatment for Crohn’s disease and an upfront payment associated with our July 2002 in-licensing of the rights to a pellet formulation of mesalamine under an agreement with Dr. Falk Pharma GmbH. The increase in research and development expenses in 2001 from 2000 was primarily due to costs associated with the preparation of the NDA for rifaximin as a treatment for travelers’ diarrhea and the ongoing multi-center study for rifaximin as a treatment for hepatic encephalopathy. To date, we have incurred research and development expenditures of approximately $15.5 million for balsalazide and $15.7 million for rifaximin. We expect research and development costs to increase as we pursue additional indications for balsalazide and rifaximin, pursue development of the mesalamine pellets product, and if and when we acquire new products.

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Selling, general and administrative expenses were $33.0 million, $24.7 million and $7.4 million, for 2002, 2001 and 2000, respectively. The increase in 2002 compared to 2001 was the result of the expansion of our commercialization infrastructure and the marketing campaign for Colazal. The substantial increase in 2001 compared to 2000 was the result of the U.S. launch of Colazal in January 2001 and increased expenditures associated with expanding our commercialization infrastructure.

Interest and other income (expenses), net was $1.1 million in 2002, $0.5 million in 2001 and $0.2 million in 2000. Interest income was significantly higher in 2002 than 2001 due to higher average cash balances resulting from the completion of the public offering in March 2002. Interest income was significantly higher in 2001 than 2000 due to higher average cash balances resulting from the completion of private placements in November 2000 and May 2001.

We experienced net losses of $24.7 million in 2002, $17.5 million in 2001 and $3.0 million in 2000.

At December 31, 2002, we had a U.S. federal net operating loss carryforward of approximately $64.0 million. This carryforward will expire on various dates beginning in 2004 through 2022 if not utilized. Utilization of the federal net operating loss and credit carryforwards might be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code. The annual limitation might result in the expiration of net operating losses and credits before utilization.

See Note 11 to our financial statements for a presentation of our quarterly results of operations for the years ended December 31, 2002 and 2001.

Liquidity and Capital Resources

Historically, we have financed product development, operations and capital expenditures primarily from funding arrangements with collaborative partners and from public and private sales of equity securities. Since launching Colazal in 2001, we have increasingly relied on cash from operations to fund our business. Cash used in our operations was $29.0 million in 2002, $16.4 million in 2001 and $2.5 million in 2000. Negative operating cash flows during 2002, 2001 and 2000 were caused primarily by operating losses. Our capital expenditures were $0.6 million in 2002, $1.3 million in 2001 and $0.2 million in 2000, with the expenditures primarily attributable to the purchase of office furniture and equipment. The increase in 2001 from 2000 was primarily the result of the relocation of our corporate headquarters in April 2001.

As of December 31, 2002, we had approximately $55.7 million in cash, cash equivalents and investments. As of December 31, 2001, we had approximately $27.9 million in cash and cash equivalents. The increase of $27.9 million was primarily due to the completion of a public offering of 4.6 million shares of our common stock in March 2002 with net proceeds of approximately $57.4 million, and the issuance of common stock upon the exercise of stock options in 2002 with net proceeds of approximately $0.4 million, offset by operating losses.

During the third quarter of 2002, we entered into a $7.0 million revolving working capital line of credit, with borrowing capacity of up to 75% of our eligible accounts receivable under 90 days old from the date of invoice. We had no outstanding balance under this line as of December 31, 2002.

As of December 31, 2002, we had non-cancelable purchase order commitments for inventory purchases of approximately $6.3 million. We anticipate significant expenditures in 2003 related to our continued sales, marketing, product launch and development efforts associated with Colazal, rifaximin and mesalamine pellets. To the extent we acquire rights to additional products, we will incur additional expenditures.

Our contractual commitments for non-cancelable purchase commitments of inventory and minimum lease obligations for all non-cancelable operating leases as of December 31, 2002 are as follows (in thousands):

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We have sustained continuing operating losses and had an accumulated deficit of $70.6 million as of December 31, 2002. We expect to incur operating losses until product revenues reach a sufficient level to support ongoing operations. In addition, in the year ended December 31, 2002, we had negative cash flows from operations of approximately $29.0 million. We believe our cash, cash equivalent and investment balances at December 31, 2002, should be sufficient to satisfy our cash requirements for at least through December 31, 2003. However, our actual cash flows might vary materially from those now planned because of a number of factors, including our success selling products, the results of research and development activities, FDA and foreign regulatory processes, establishment of and change in relationships with strategic partners, technological advances by us and other pharmaceutical companies, the terms of our collaborative arrangements with strategic corporate partners, the status of competitive products and whether we acquire rights to additional products. We might seek additional debt or equity financing or both to fund our operations. If we increased our debt levels, we might be restricted in our ability to raise additional capital and might be subject to financial and restrictive covenants. If we issued additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements with corporate partners that could provide us with additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all.

Cautionary Statement

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. The following statement highlights some of these risks.

Statements contained in this Form 10-K which are not historical facts are or might constitute forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be attained. Forward-looking statements involve known and unknown risks that could cause our actual results to differ materially from expected results. Factors that could cause actual results to differ materially from our expectations include, among others: our limited sales and marketing experience; the high cost and uncertainty of the research, clinical trials and other development activities involving pharmaceutical products; our ability to fund our activities internally or through additional financing, if necessary; the unpredictability of the duration and results of regulatory review of New Drug Applications and Investigational New Drug Applications; our dependence on our first three pharmaceutical products, balsalazide, rifaximin and granulated mesalamine and the uncertainty of market acceptance of those products; the possible impairment of, or inability to obtain, intellectual property rights and the costs of obtaining such rights from third parties; intense competition; the uncertainty of obtaining, and our dependence on, third parties to manufacture and sell our products; and results of future litigation and other risk factors detailed from time to time in our other SEC filings. We do not undertake any obligation to release publicly any revisions to these statements to reflect later events or circumstances or to reflect the occurrence of unanticipated events.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Our purchases of raw materials and our product sales to our European distribution partners are denominated in Euros. Translation into our reporting currency, the United States dollar, has not historically had a material impact on our financial position. Additionally, our net assets denominated in currencies other than the functional currency have not exposed us to material risk associated with fluctuations in currency rates. Given these facts, we have not considered it necessary to use foreign currency contracts or other derivative instruments to manage changes in currency rates.

Pursuant to our investment policy, we have invested a portion of our available cash in government agency and high-grade corporate bonds. Due to the nature and maturity terms of these investments, we do not believe these investments present significant market risk.

Item 8. Financial Statements and Supplementary Data

The information required by this Item is set forth in the Consolidated Financial Statements and Notes thereto beginning at page F-1 of this Report.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

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PART III

Item 10. Directors and Executive Officers of the Registrant

Information required by this Item concerning our directors is incorporated by reference from the section captioned “Election of Directors” contained in our proxy statement related to the 2003 Annual Meeting of Stockholders scheduled to be held on June 19, 2003, which we intend to file with the SEC within 120 days of the end of our fiscal year pursuant to General Instruction G(3) of Form 10-K. The information required by this Item concerning executive officers of the Registrant is set forth in Part I of this report. The information required by this Item concerning compliance with Section 16(a) of the United States Securities Exchange Act of 1934, as amended, is incorporated by reference from the section of the proxy statement captioned “Section 16(a) Beneficial Ownership Reporting Compliance.”

Item 11. Executive Compensation

The information required by this Item is incorporated by reference to the information under the section captioned “Executive Compensation” contained in the proxy statement.

Item 12. Security Ownership of Certain Beneficial Owners and Management

The information required by this Item is incorporated by reference to the information under the section captioned “Security Ownership of Management and Certain Beneficial Owners” and “Equity Compensation Plan Information” contained in the proxy statement.

Item 13. Certain Relationships and Related Transactions

The information required by this Item is incorporated by reference to the information under the sections captioned “Compensation Committee Interlocks and Insider Participation” and “Certain Transactions” contained in the proxy statement.

Item 14. Controls and Procedures

(a) Evaluation of disclosure controls and procedures. As of a date within ninety days before the filing date of this annual report our Principal Executive Officer and Principal Financial Officer reviewed and evaluated the effectiveness of out disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c)). Based on that evaluation, the Principal Executive Officer and Principal Financial Officer have concluded that our current disclosure controls and procedures are effective.

(b) Changes in internal controls. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of evaluation.

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PART IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

(A) 1. Financial Statements

The following statements are filed as part of this report:

Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the consolidated financial statements or notes thereto.

3. Exhibits

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(B) Reports On Form 8-K.

During the three months ended December 31, 2002, we filed seven reports on Form 8-K, dated October 3, October 21, October 25, October 28, November 5, November 8 and December 19, 2002. Our filing dated October 3, 2002 disclosed a press release where we announced that we would present at the UBS Warburg Global Life Sciences Conference on Thursday, October 10, 2002. The filing dated October 21, 2002 disclosed that we filed a press release announcing that we would report third quarter 2002 financial results before the market opened on Monday, October 28, 2002. The October 25, 2002 filing disclosed that we had issued a press release announcing that we had received an approvable letter from the U.S. Food and Drug Administration for the New Drug Application for rifaximin. The filing on October 28, 2002 announced our operating results for the quarter ended September 30, 2002. The November 5, 2002 filing disclosed a press release announcing that we would present at the CIBC World Markets Thirteenth Annual Health Care Conference on Wednesday, November 6, 2002. The filing on November 8, 2002 disclosed a press release where we announced that we would present at the Credit Suisse First Boston Health Care Conference on Wednesday, November 13, 2002. The filing on December 19, 2002 disclosed a press release announcing that Dr. Allen Mangel, Vice President, Research and Development, had resigned from the Company to pursue other interests.

(C) Exhibits

See Item 15(a)(3) above.

(D) Financial Statement Schedules

See Item 15(a)(1) above.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below by the following persons on behalf of the Registrant and on the dates indicated.

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CERTIFICATION

I, Carolyn J. Logan, certify that:

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CERTIFICATION

I, Adam C. Derbyshire, certify that:

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SALIX PHARMACEUTICALS, LTD.

Index to Consolidated Financial Statements

Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the consolidated financial statements or notes thereto.

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REPORT OF INDEPENDENT AUDITORS

The Board of Directors

Salix Pharmaceuticals, Ltd.

We have audited the accompanying consolidated balance sheets of Salix Pharmaceuticals, Ltd. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedule, listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Salix Pharmaceuticals, Ltd. and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

/s/ ERNST & YOUNG LLP

Raleigh, North Carolina

February 7, 2003

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SALIX PHARMACEUTICALS, LTD. AND SUBSIDIARIES

Consolidated Balance Sheets

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

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SALIX PHARMACEUTICALS, LTD. AND SUBSIDIARIES

Consolidated Statements of Operations

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

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SALIX PHARMACEUTICALS, LTD. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity