LEATHER FACTORY INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-K

(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1997

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period ________ to ________

Commission File Number 1-12368

THE LEATHER FACTORY, INC.
(Exact name of registrant as specified in its charter)

Delaware 75-2543540
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

3847 East Loop 820 South
Fort Worth, Texas 76119
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (817) 496-4414

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

Title of Each Class Name of Each Exchange on Which Registered
------------------- -----------------------------------------
Common Stock, par value $.0024 American Stock Exchange

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

NONE

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]

The aggregate market value of the common stock held by non-affiliates of
the registrant was approximately $1,435,034 at March 18, 1998. At that date
there were 9,853,161 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Certain portions of the Registrant's definitive Proxy Statement for the
Annual Meeting of Stockholders to be held on May 21, 1998 are incorporated by
reference in Part III of this report.

PART I

Item I. Business.

General Development of Business

The Leather Factory, Inc. ("TLF" or the "Company") was incorporated under
the laws of the State of Colorado in 1984 and reincorporated under the laws of
the State of Delaware in June 1994. TLF is the successor to several entities
that were parties to a merger transaction in July 1993. One of these entities
involves a business that was incorporated pursuant to the laws of the State of
Texas in 1980. The Company's principal offices are located at 3847 East Loop 820
South, Fort Worth, Texas 76119 and its phone number is 817/496-4414.

Refinancing. On November 21, 1997, the Company entered into a Loan and
Security Agreement with FINOVA Capital Corporation ("FINOVA"), according to
which FINOVA agreed to provide a credit facility of up to $9,136,000 in senior
debt (the "Senior Debt Facility"). The Senior Debt Facility has a two-year term
and is secured by all of the assets of the Company as well as a pledge of
3,000,000 shares of the Company's common stock, par value $.0024 ("Common
Stock"), collectively owned by two of the Company's executive officers.
Simultaneously, the Company also issued at face value its $1,000,000
subordinated promissory note to The Schlinger Foundation (the "Subordinated
Debenture"). The Subordinated Debenture also has a two-year maturity and is
partially secured by a pledge of 2,666,666 shares of the Company's common stock
owned by another executive officer.

Proceeds of these financings were used to pay all amounts due and owing by
the Company to NationsBank of Texas, N.A. ("NationsBank"). The Company's
revolving line of credit and term loan facility with NationsBank in the
principal amounts of $5,125,000 and $2,200,000, respectively, were satisfied in
their entirety. The Company had been in continuing default under the terms of
its financing arrangements with NationsBank since June 30, 1996 and had operated
pursuant to the provisions of certain forbearance agreements by and between the
Company and NationsBank since that date. The default involved the Company's
violation of covenants dealing solely with the failure to meet certain
prescribed financial ratios. The Company at no time failed to make a payment of
principal or interest on its indebtedness to NationsBank.

The Company used the remaining proceeds to pay financing costs. The Company
is currently in compliance with all covenants and conditions contained in the
Senior Debt Facility and the Subordinated Debenture and has no reason to believe
that it will not continue to operate in compliance with the provisions of these
financing arrangements. The principal terms and conditions of the Senior Debt
Facility and the Subordinated Debenture are described below, see "Management's
Discussion and Analysis of Financial Conditions and Results of Operations -
Capital Resources and Liquidity" and Note 3 to the Consolidated Financial
Statements.

Improved Operating Results. The Company significantly improved its results
from operations during the current year. Net income improved from a loss of
$989,768 for the year ended December 31, 1996, to net income of $70,292 for the
1997 year. In its plan to return to profitability, the Company focused its
attention during 1997 on improving gross profit margins and lowering operating
expenses. Gross profit as a percentage of sales increased from 37.4% for the
year ended December 31, 1996 to 41.6% for the current year. Operating costs as a
percentage of sales fell 1.6 percentage points or $1,503,686 in actual dollar
terms during the 1997 year compared to 1996, due to cost control measures
instituted by management during the latter part of 1996 and in the current year.
Some of the gross profit increases and operating expense reductions came at the
expense of lower sales, which decreased $2,854,516 or 10.1% during the year
ended December 31, 1997 from the amounts generated in 1996. See also
"Management's Discussion and Analysis of Financial Conditions and Results of
Operations - General; - Costs, Gross Profit, and Expenses; and - Capital
Resources and Liquidity."

Opening of New Sales/Distribution Units and Acquisitions. In a departure
from the last several years, due to the financial constraints involved with
operating under forbearance arrangements with NationsBank, as well as
management's focus on improving the results of existing operations, the Company
did not close an acquisition or open a new location during the year ended
December 31, 1997. Subject to remaining in compliance with the provisions of the
Senior Debt Facility and the Subordinated Debenture, and management's desire to
achieve even greater improvements in existing operations, the Company will
resume its expansion plans. See also "-Expansion and Acquisition Strategy" and
"Management's Discussion and Analysis of Financial Conditions and Results of
Operations - General; - Capital Resources and Liquidity."

New Computer System. The Company installed a new computer system in its
central warehouse and largest sales/distribution unit. This new system has also
been installed in the Company's accounting department. The Company is in the
process of implementing the new system to achieve point-of-sale and perpetual
inventory capabilities as well as to obtain certain sales and financial
information more rapidly. Once the system is fully operational in the Company's
central locations in Fort Worth, Texas, the new computer system will be
installed and implemented in phases in the Company's other sales/distribution
units.

2

Narrative Description of Business

Background. TLF operates in one industry segment as an international
wholesale manufacturer and distributor of a broad product line which includes
leather, leatherworking tools, buckles and other belt supplies, shoe care and
repair supplies, leather dyes and finishes, adornments for belts, bags, and
garments, saddle and tack hardware, and do-it-yourself kits. The Company,
through its subsidiary, Roberts, Cushman & Company, Inc. ("Cushman"), in New
York, New York, produces a related product line involving hat trims, the
decorative piece of material that adorns the outside of a hat, and small
finished leather goods such as cigar cases, wallets and western accessories. The
Company frequently introduces new products either through its own manufacturing
capability or through purchasing from vendors. The Company holds a substantial
number of copyrights for its designs. These designs have been incorporated
throughout the Company's product line as a means of increasing its competitive
advantage.

The Company's customer base is comprised of over 40,000 customers including
retailers, wholesalers, assemblers, distributors, and other manufacturers
dispersed geographically throughout the world. The majority of the Company's
customers are wholesalers. TLF sells inventory ranging from raw materials to
finished goods.

The Company manufactures some of its own products, but also purchases
products from other manufacturers and distributors in fourteen countries. The
Company has light manufacturing facilities in Fort Worth, Texas, where it
produces items such as suede lace, garment fringe, leathercraft and
craft-related kits, and in New York, New York, where, through its Cushman
subsidiary, it produces hat trims and small finished leather goods, as noted
above.

The Company distributes its products through 21 sales/distribution units
located in seventeen states and one located in Canada plus its manufacturing
facility and show room in New York. The geographic location of its
sales/distribution units is selected based on the location of its customers, so
that delivery time to customers is minimized. A two-day maximum delivery time is
the Company's goal. In addition to offering its customers rapid delivery, the
Company also offers a "one-stop shopping" concept for both leather and
leathercraft materials.

Corporate History. The Company is the successor to certain entities that
were parties to a series of transactions including a merger in July 1993 which
involved The Leather Factory, Inc., a Texas corporation ("TLF-Texas"), and
National Transfer & Register Corp. ("National"), a Colorado corporation, which
had no operations and whose capital stock had no active trading market prior to
the merger. The surviving entity changed its name to The Leather Factory, Inc.
and its business became that conducted by TLF-Texas. National was incorporated
under the laws of Colorado in 1984 and conducted business as a stock transfer
agency from January 1985 to April 1993. In June of 1993, the principal officers
and directors of TLF-Texas, Wray Thompson, Ronald C. Morgan and Robin L. Morgan,
acquired shares of National Common Stock and were elected to National's Board of
Directors.

In July of 1993, pursuant to a reverse merger agreement among National,
TLF-Texas, and the shareholders of TLF-Texas, National acquired all of the
outstanding Common Stock of TLF-Texas in exchange for 7,805,478 newly issued
shares of National Common Stock. In connection with this transaction, National
effected a 1 for 24 reverse stock split. The name of National was changed to
"The Leather Factory, Inc.", and National's business became that conducted by
TLF-Texas. Any reference to "Company" herein includes, where applicable, the
activities of TLF-Texas after the acquisition of TLF-Texas by National.

TLF-Texas was initially incorporated under the laws of Texas in 1980 with
the name Midas Leathercraft Tool Company ("Midas"). Originally, the business of
Midas involved the distribution of certain leathercraft tools. After the reverse
merger transaction with National, the Company in June of 1994 reincorporated in
Delaware. As part of its strategy to develop a multi-location chain of wholesale
units the Company has made numerous acquisitions since its incorporation,
including the purchase of six wholesale units from Brown Group, Inc., a major
footwear retailer. The Company has also acquired several businesses located
throughout the United States that distribute shoe-related supplies to the shoe
repair and shoe store industry. In addition, the Company purchased Cushman in
1995, a leading producer of hat trims. In March of 1996, the Company acquired
all of the issued and outstanding capital stock of its Canadian distributor, The
Leather Factory of Canada.

Business Concept. Wray Thompson and Ronald C. Morgan, the Company's
founders, conceived "The Leather Factory Concept." This concept includes the
geographical location and type of space rented for the Company's
sales/distribution units, the size and configuration of the units, the number of
items comprising the merchandise line, the utilization of direct mail, including
the use of an annual full-line catalog, and the application of rapid delivery to
customers.

3

The Company's 22 sales/distribution units combine the economies of scale of
warehouse locations with the marketing efficiencies that can be achieved through
direct mail. Walk-in traffic and mail order customers are served in the same
location. The type of premises utilized for the sales/distribution unit
locations is generally light industrial office/warehouse space in proximity to a
major freeway or with relatively easy access thereto. This kind of location
typically provides lower rental expense compared to other more retail oriented
locations. The size and configuration of the sales/distribution units are
carefully planned to allow large quantities of product to be displayed in an
easily accessible and visually appealing manner. Leather is displayed by the
pallet where the customer can see and touch it, assessing first-hand the
numerous sizes, styles, and grades of leather and leather goods. The Company
maintains higher inventory levels of certain imported items to assure itself of
a continuous allotment due to the length of time required for delivery of these
items.

The Company's sales/distribution units are staffed by experienced managers
who are primarily compensated based upon the operating profit of their location.
Sales of these units are generated by the selling efforts of the location
personnel themselves, participation by the Company at trade shows, the use of
sales representative organizations and the aggressive use of direct mail
advertising. In addition to generating mail order business, the purpose of the
Company's direct mail program is to stimulate sales for the sales/distribution
units. The Company utilizes an internally developed and maintained mailing list
which allows for very targeted mailing to its various customer groups. As for
the utilization of direct mail and rapid delivery, the Company locates units in
order to get merchandise in the customers' hands as soon as possible, with the
added benefit of lower freight cost.

The Company attempts to maintain the number of stock-keeping units
("SKU's") in the primary Leather Factory line of merchandise at the optimum
number of items necessary to balance the maintaining of the proper stock to
minimize stock-out situations with the carrying costs involved with such an
inventory level. The number of SKU's has been refined over the years due to the
introduction of new products as well as the discontinuing of items from the
product line. The Company now maintains 2,357 items in The Leather Factory line
of merchandise, and the product line sold to shoe repair shops and shoe stores
increases the number in the Company's overall product line to approximately
4,000 SKU's.

Expansion and Acquisition Strategy. In past years the Company has made
several acquisitions and opened new sales/distribution units. The acquisition
strategy involved: (a) the purchase of businesses selling a related product line
to which The Leather Factory line of merchandise and Concept could be added; and
(b) the purchase of related businesses. The results of these activities have
been mixed principally due to the impact upon the Company of negative market
forces, which affected the integration and results of these companies acquired
or new locations instituted, as well as due to a protracted labor dispute at the
Cushman facility. Market conditions have been challenging in the areas of the
western and craft industries served by the Company for some time. For example,
conditions in the western industry peaked in 1994 and the trends have been
generally negative in that industry since that time. These trends, coupled with
the labor dispute at Cushman which was resolved in 1996, have affected the sales
and profitability of the Company's Cushman acquisition. The Company's
acquisition of businesses involved in the distribution of shoe care and repair
supplies have been only marginally profitable because of competitive pressures.

In 1997, management focused on stabilizing operations and obtaining
long-term financing, and no acquisitions were made. Subject to obtaining the
necessary financing and the demands of existing operations, the Company
currently plans to resume its expansion by: (i) adding one to two
sales/distribution units per year; and (ii) acquiring companies in related
areas/markets which offer synergistic aspects based on the locations and/or
product lines of the businesses.

It is anticipated that the Company would not acquire a business that sells
shoe care and repair supplies as a means of gaining a new Leather Factory
location as it has several times in the past. The Company has determined that it
is better to open new locations than to purchase these existing shoe-related
businesses. The opening of a new location requires approximately $100,000 in
inventory and $25,000 in fixtures, plus the investment in accounts receivable
during the initial phase of a new unit. Management believes that new locations
can be financed internally.

The financing of acquisitions is dependent upon the Company's working
capital line of credit with FINOVA and subject to the size of the acquisition,
will require the Company to seek additional financing. Management can give no
assurances as to its ability to obtain such financing.

4

Products/Customers. The Company's core business consists of manufacturing,
importing and distributing leather, traditional leathercraft materials
(do-it-yourself kits, stamping sets, and leatherworking tools), craft-related
items (leather lace, beads, and wearable art accessories), hardware, metal
garment accessories (belt buckles, belt buckle designs, and conchos), fancy hat
trims in braids, leather, and woven fabrics, shoe care and repair supplies,
leather finishes, and small finished leather goods. The Company's manufacturing
operations are in Fort Worth, Texas and New York, New York at Cushman. The
products manufactured in Fort Worth generally involve cutting leather into
various shapes and patterns using metal dies ("clicking"), fabrication,
assembly, and packaging/repackaging tasks. The manufacturing operation in Fort
Worth makes items primarily for wholesale distribution using the Company's
sales/distribution units or for drop-shipment directly to customers through the
central warehouse. The Cushman facility manufactures hat trims and small
finished leather goods. Hat trims are sold to hat manufacturers and distributors
directly. Small finished leather goods are sold to various distributors and
retailers through attendance at trade shows and the use of sales
representatives.

The customer groups served include wholesale distributors, tack and saddle
shops, shoe-findings customers, institutions, prisons and prisoners, dealer
stores, western stores, craft stores and craft store chains, hat manufacturers
and distributors, other large volume purchasers, manufacturers, and retailers.
No single customer's sales comprise more than 10% of the Company's total sales.
Approximately 4% of the Company's sales are export sales.

Competition. The Company competes in four highly fragmented markets which
include leathercraft, leather accessories, retail craft, and shoe care and
repair supplies. Management believes that the Company encounters competition in
connection with certain product lines and in certain areas from different
companies, but has no direct competition affecting the entire product line. The
Company is larger than most of its direct competitors. The fragmented nature of
these markets is the primary reason for the lack of broad-based competition.

The Company competes on price, availability of merchandise, and speed of
delivery. The size of the Company relative to most of its competitors creates
competitive advantage in its ability to stock a full range of products as well
as in buying merchandise. The Company believes it has a competitive advantage on
price in most product lines because it purchases in bulk and has an
international network of suppliers that can provide quality merchandise at lower
costs. Most of the Company's competitors do not have the multiple sources of
supply and cannot purchase sufficient quantities to compete along a broad range
of products. In fact, some of the Company's competitors are also customers,
relying on the Company as a supplier.

Suppliers. The Company currently purchases merchandise and raw materials
from approximately 200 vendors dispersed throughout the United States as well as
in fourteen foreign countries. In fiscal year 1997, the Company's ten largest
vendors accounted for approximately 53% of its total purchases. Management
believes that its relationships with suppliers are strong and does not
anticipate any material changes in these supplier relationships in the future.
Due to the number of alternative sources of supply, the loss of any or all of
these principal suppliers would not have a material impact on the operations of
the Company.

Patents and Copyrights. The Company presently owns 130 copyrights covering
238 registered works with one work pending, seven trademarks covering seven
names with one trademark application pending, and two patents covering three
products. Registered trademarks include a federal trade name registration on The
Leather Factory. The trademarks expire at various times starting in 2002 and
ending in 2007, but can be renewed indefinitely. Most copyrights granted or
pending are on metal products, such as conchos, belt buckles, etc., and
instruction books. The expiration period for the copyrights begins in 2062 and
ends in 2071. The Company has patents on two belt buckles and certain
leather-working equipment known as the "Speedy Embosser." The patents expire in
2011. Management considers these intangibles to be valuable assets and defends
them as necessary.

Compliance With Environmental Laws. Compliance by the Company with federal,
state and local environmental protection laws has not had, and is not expected
to have, a material effect upon capital expenditures, earnings or the
competitive position of the Company.

5

Employees. As of December 31, 1997, the Company employed 214 people, with
206 on a full time basis. The Company is not a party to any collective
bargaining agreement. Eligible employees participate in The Leather Factory,
Inc. Employees' Stock Ownership Plan and Trust ("ESOP"). As of December 31,
1997, 169 employees and former employees were participants in or beneficiaries
of the ESOP. The Company has the option of contributing up to 15% of eligible
employees' compensation into the ESOP. Net contributions for 1997, 1996 and 1995
were 1.2%, .8%, and .8% respectively of eligible compensation. These
contributions are used to purchase shares of Common Stock.

In late October 1995, representatives of Union Local 62-32 of the Union of
Needletrades, Industrial, and Textile Employees ("UNITE") requested that the
Company's wholly owned subsidiary, Cushman, recognize UNITE as the sole and
exclusive employee bargaining representative. The Company responded by declining
to recognize UNITE unless a secret ballot election was held by the employees of
Cushman. On October 31, 1995, the employees of Cushman went on strike in New
York City for the purpose of securing representation. Virtually all of the 50
hourly employees of Cushman refused to cross the picket line. The Company filed
charges with the National Labor Relations Board ("NLRB") alleging that picket
line misconduct and violence was inspired by UNITE.

The strike lasted from October 31, 1995 to April 1, 1996, at which time
UNITE notified the Company that it would cease all organizing actions so long as
an unconditional return to work was made to all employees who had refused to
cross the picket line. On August 1, 1996, a secret ballot election was held and
the union was defeated.

On September 6, 1996, Cushman and UNITE entered into a settlement agreement
approved by the NLRB, to completely settle and resolve the issues noted above
without the need for a trial. While not admitting that Cushman committed a
violation of the National Labor Relations Act (the "Labor Act") or that the
employees engaged in an unfair labor practice strike, Cushman did agree to post
a notice in English and Spanish informing employees of their rights pursuant to
the Labor Act and Cushman's agreement to not: (i) interrogate employees relative
to union activities; (ii) threaten employees with the relocation of the business
if they support UNITE or any other labor organization; (iii) warn or advise
employees that their continued employment is conditioned upon their abandonment
of their support for UNITE or any other labor organization; and (iv) interfere
with, restrain or coerce employees in the exercise of the rights guaranteed them
by the Labor Act.

Except for any residual affects due to attempts by UNITE to organize
employees of Cushman as described above, management believes that relations with
employees are good.

6

Item 2. Properties.

The Company leases all its premises. The Company sold its only owned
location on December 15, 1997. This property, which was a 13,287 square foot
office/warehouse building located on a 16,550 square foot site in Tampa,
Florida, was pledged as collateral under the Company's Senior Debt Facility with
FINOVA. A portion of the indebtedness to FINOVA, in the principal amount of
$236,000, was paid from the net proceeds received upon the sale.

Detailed below are the lease terms for the Company's locations. The general
character of each location is light industrial office/warehouse space, except
for the New York City premises which is standard light industrial loft space in
a multi-story building. The Company believes that all of its properties are
adequately covered by insurance.

Location Name Total Space (Sq. Ft.) Minimum Annual Rent * Lease Expiration
------------- --------------------- ------------------- ----------------

Chattanooga, TN 9,040 $ 40,704 May 1999
Denver, CO 12,000 39,000 October 1999
Harrisburg, PA 6,850 36,665 March 2002
Fort Worth, TX 61,000 238,835 March 2003
Fresno, CA 5,600 41,807 March 2002
Des Moines, IA 4,000 30,718 April 1999
Phoenix, AZ 4,500 25,679 March 2001
Springfield, MO 6,000 20,400 July 1998
Spokane, WA 5,400 20,400 February 1999
Albuquerque, NM 5,000 27,600 October 1998
Salt Lake City, UT 4,000 25,584 September 1999
Baldwin Park, CA 7,800 52,200 March 2000
Tampa, FL 5,238 37,604 January 2003
San Antonio, TX 5,600 40,320 October 2001
Columbus, OH 6,000 38,270 October 2000
El Paso, TX 9,600 44,122 July 1998
Oakland, CA 8,000 57,304 December 2003
Grand Rapids, MI 8,000 33,951 March 1999
Wichita, KS 14,000 33,600 May 1999
New York, NY 12,000 94,080 September 1998
New Orleans, LA 5,130 21,600 August 2000
Charlotte, NC 6,202 24,188 February 2001
Winnipeg, Canada 5,712 28,085** November 2002
-------- -----------
Totals 216,672 $ 1,052,716
======== ===========

* Represents the average minimum annual rent over the balance of the
unexpired lease term.
** As converted into U.S. dollars.

The Company's Fort Worth location includes the Fort Worth
sales/distribution unit, the Company's central warehouse, the light
manufacturing facility, and the sales and administrative/executive offices. The
Company also leases a 624 square foot showroom in the Denver Merchandise Mart
for $10,920 per year. This lease will expire in October 1998.

7

Item 3. Legal Proceedings.

The Company, as successor-in-interest to National, has been a defendant in
a lawsuit brought in July 1994 by Gary A. Bedini and John C. Bedini (the
"Plaintiffs") in the United States District Court for the District of Colorado.
Additional defendants are Securities Transfer Corporation, a Texas corporation
("STC"), and Steven Jay Olson, individually, and as President and Director of
National, now known as The Leather Factory, Inc. The Plaintiffs alleged that in
1992, pursuant to SEC Rule 144(k), they sought to transfer approximately 1.5
million shares of their Common Stock in Gamma Electronic Systems, Inc., and that
the transfer agent, National, improperly refused. The Plaintiffs sought
compensatory damages in the amount of $2.1 million as well as punitive damages.
The Company is contractually indemnified from and against all losses that may
arise out of this cause of action, including attorneys' fees, by STC and/or
related entities.

This action was tried in July 1995. Upon the conclusion of the trial, the
judge found in favor of one plaintiff, Gary Bedini, and against the defendants
in the amount of $50,468, and similarly for the other plaintiff, John Bedini,
and against the defendants in the amount of $68,548. The written judgment of the
court (the "Judgment"), which reflected the aforementioned rulings by the trial
judge, was entered on September 7, 1995. This Judgment also included pre
judgment interest of $16,159 for Gary Bedini and $21,947 for John Bedini. Post
judgment interest continues to accrue from the date of the Judgment, pursuant to
federal law.

According to the terms of its contractual indemnification obligations, STC
has defended this litigation at its expense. On September 21, 1995, STC filed
Defendants' Motion to Alter or Amend Judgment (the "Motion"). The Plaintiffs
filed a response to this Motion on October 4, 1995, and said Motion remains
pending. In addition to the Motion, STC has made a settlement offer. STC has
informed the Company if the case does not settle, and the Motion is denied, then
STC intends to appeal the Judgment and to post either a supersedeas bond or cash
to avoid collection of the Judgment while the appeal is pending. As of March
1998, no action has been taken by the trial judge relative to the Motion.
Pursuant to the Indemnification Agreement between STC and the Company dated
October 17, 1994, the Company believes it will not suffer any loss due to the
action described here and above.

The Company has litigation in the ordinary course of its business. Other
than described above, the Company is not a party to any material pending legal
proceedings.

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

There were no matters submitted to a vote of the Company's security holders
during the fourth quarter of the Company's fiscal year ended December 31, 1997.

8

PART II

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

The Common Stock of the Company is traded on the American Stock Exchange
using the symbol TLF. The high and low prices for each calendar quarter during
the last two fiscal years are as follows:

Quarter Ended High Low

March 31, 1996 $2.6875 $1.7500
June 30, 1996 2.1250 1.7500
September 30, 1996 1.9375 1.4375
December 31, 1996 1.4375 0.8125

March 31, 1997 1.0000 0.5625
June 30, 1997 0.8125 0.5000
September 30, 1997 0.8750 0.5625
December 31, 1997 0.8125 0.5000
- ----------
There were approximately 585 stockholders of record on March 18, 1998.

There have been no cash dividends paid on the shares of the Company's
Common Stock and currently dividends cannot be declared or paid without the
prior written consent of FINOVA Capital Corporation, the Company's senior
lender. The Board of Directors has historically followed a policy of reinvesting
the earnings of the Company in the expansion of its business. This policy is
subject to change based on current industry and market conditions, as well as
other factors beyond the control of the Company.

9

Item 6. Selected Financial Data.

The selected financial data presented below are derived from and should be
read in conjunction with the Company's Consolidated Financial Statements and
related notes. This information should also be read in conjunction with Item 7 -
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

Years Ended December 31
- ---------------------------
Income Statement Data
---------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993
--------------- ---------------- ---------------- ---------------- ----------------

Net sales $25,399,116 $28,253,632 $31,447,849 $28,081,272 $24,371,082
Cost of sales 14,844,376 17,689,973 18,446,378 15,870,603 13,555,345
--------------- ---------------- ---------------- ---------------- ----------------
Gross profit 10,554,740 10,563,659 13,001,471 12,210,669 10,815,737

Operating expenses 9,365,673 10,869,359 10,363,159 9,573,495 8,631,600
--------------- ---------------- ---------------- ---------------- ----------------
Operating income (loss) 1,189,067 (305,700) 2,638,312 2,637,174 2,184,137

Other (income) expense 887,543 1,000,604 678,264 142,830 149,955
--------------- ---------------- ---------------- ---------------- ----------------

Income (loss)
before income taxes 301,524 (1,306,304) 1,960,048 2,494,344 2,034,182
Income tax provision (benefit) 231,232 (316,536) 786,744 990,197 875,362*
--------------- ---------------- ---------------- ---------------- ----------------

Net income (loss) 70,292 (989,768) 1,173,304 1,504,147 1,158,820*
=============== ================ ================ ================ ================

Earnings (loss) per share** .01 (.10) .12 .15 .13*
=============== ================ ================ ================ ================

Earnings (loss) per share--
assuming dilution** .01 (.10) .12 .15 .13*
=============== ================ ================ ================ ================

Weighted average common
shares outstanding for:

Basic EPS 9,789,358 9,788,530 9,789,468 9,783,387 8,801,422
=============== ================ ================ ================ ================

Diluted EPS 9,791,565 9,788,530 9,789,468 9,783,387 9,035,568
=============== ================ ================ ================ ================

Balance Sheet Data
---------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993
--------------- ---------------- ---------------- ---------------- ----------------

Total Assets $17,024,549 $18,264,547 $19,333,376 $18,468,806 $9,555,881
--------------- ---------------- ---------------- ---------------- ----------------

Notes payable and current
maturities of long term debt 4,650,742 8,549,366 1,296,359 194,311 216,572
--------------- ---------------- ---------------- ---------------- ----------------

Notes payable and long-term
debt, net of current maturities 2,602,728 17,378 6,566,809 7,325,432 1,189,856
--------------- ---------------- ---------------- ---------------- ----------------

Total Stockholders' Equity 8,132,646 8,022,937 9,282,305 8,217,781 5,502,452
=============== ================ ================ ================ ================

* Includes charge of $98,772 or $0.01 per share reflecting cumulative effect on
prior years of a change in accounting method for income taxes (SFAS 109).

** The earnings (loss) per share amounts prior to 1997 have been restated to
comply with Statement of Financial Accounting Standards No. 128, Earnings Per
Share. Such restatement did not change previously reported amounts. See notes 2
and 8 to the consolidated financial statements for further discussion of
earnings per share.

10

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

General

The Leather Factory, Inc. ("TLF" or the "Company") is an international
manufacturer and wholesale distributor of a broad product line which includes
leather, leatherworking tools, buckles and other belt supplies, shoe care and
repair supplies, leather dyes and finishes, adornments for belts, bags, and
garments, saddle and tack hardware, and do-it-yourself kits. The Company,
through its subsidiary, Roberts, Cushman & Company, Inc. ("Cushman"), in New
York, New York, produces hat trims, the decorative piece of material that adorns
the outside of a hat, and small finished leather goods and accessories.

The Company principally promotes its products through the use of targeted
direct mail advertising. Proprietary mailing lists by customer groups are
maintained by the Company. These valuable mailing lists have been generated
internally and have never been sold to third parties. The sales from direct
mailings are serviced by the Company's 21 sales/distribution units located in 17
states and one in Canada. These locations offer one-stop shopping and are placed
geographically to ensure rapid delivery to the customer.

In addition to marketing capability, the Company performs light
manufacturing as well as packaging tasks in its manufacturing facilities located
in Fort Worth, Texas and New York, New York. If the Company cannot manufacture
an item on a cost effective basis, the product will be located and purchased
from virtually anywhere in the world. The Company currently procures goods in 14
countries around the world.

The Company frequently introduces new products either through its own
manufacturing capability or through purchasing from vendors. One indication of
the Company's expertise in the area of product development is the substantial
number of copyrighted designs which the Company owns. These designs have been
incorporated throughout the Company's product line, including hat trims, as a
means of increasing its competitive advantage.

Results of Operations

Income Statement Comparison

The following table sets forth, for the fiscal years indicated, certain
items from the Company's Consolidated Statements of Income expressed as a
percentage of net sales:

1997 1996 1995
--------------- -------------- --------------
Net Sales 100.0% 100.0% 100.0%

Cost of sales 58.4 62.6 58.7
--------------- -------------- --------------
Gross profit 41.6 37.4 41.3

Operating expenses 36.9 38.5 33.0
--------------- -------------- --------------
Income (loss) from operations 4.7 (1.1) 8.3

Other (income) expense, net 3.5 3.5 2.1
--------------- -------------- --------------
Income (loss) before
income taxes 1.2 (4.6) 6.2

Provision (benefit) for income tax 0.9 (1.1) 2.5
--------------- -------------- --------------
Net income (loss) 0.3% (3.5)% 3.7%
=============== ============== ==============

Analysis of 1997 Compared to 1996

Revenues

The Company's net sales decreased by 10.1% to $25,399,116 during 1997 from
$28,253,632 in 1996. This sales decline was a result of the negative forces at
the retail level that existed in some of the Company's markets as well as the
Company's plan to achieve greater margins through higher prices which led to a
lower volume of sales. The Company experienced reduced revenues of $1,507,140 in
sales of western or southwestern related products and $983,399 in sales to the
retail craft industry.

11

With the bankruptcy and reorganization of another craft retailer during
1997, Old America Stores (Ben Franklin filed for bankruptcy protection in 1996),
as well as the retrenchment by other retailers, the Company experienced another
year of reduced sales to the retail craft market. The Company's attempts in cost
cutting may have also contributed to decreased sales to the retail craft
industry. For instance, in late 1996, the Company terminated its relationships
with many of the sales representative organizations that provided sales and
customer support to the retail craft industry. The Company assumed these
responsibilities directly and saved approximately $170,000 in commissions during
1997. This was certainly at the expense of some amount of sales although it is
difficult to quantify since many large craft retailers prefer to deal directly
with the Company anyway.

Similar market conditions existed for the Company in its product lines that
were western-related. Sales by retailers of western apparel and accessories have
generally been in decline since 1994. This negatively impacted the Company's
sales of its products to these retailers as well as its sales to other western
apparel and accessory manufacturers. For example, Cushman manufactured and sold
fewer hat trims in part because fewer western hats were being sold.

In addition to sales declines due to negative external forces, the Company
initiated and implemented certain strategies during the year that resulted in
lower sales. Prices in lower margin product lines were selectively increased and
certain products were eliminated from these lines. For example, the Company's
line of products relating to shoe care and repair was reduced by more than
one-half during the year. Also, less focus was placed on sales involving high
volume but low margins such as sales of bulk leather. These merchandising and
pricing strategies contributed to the sales decline by approximately $950,000.
This decline was partially offset by increases generated in the Company's
growing line of finished leather accessories and an increase in export sales.
Finished leather accessory sales and export sales made up 2% and 4%,
respectively of the Company's sales during 1997 and increased at the rates of
182.8% and 15%, respectively. These increases in leather accessory and export
sales reflect efforts of the Company to introduce new products and seek out new
opportunities to sell its existing product lines.

Management believes that the financial and operational aspects of the
business have stabilized and new attention can be directed to increasing sales
in 1998. Market research has been conducted by the Company in order to determine
how to better serve some of its core customer groups, and during 1998 the
Company intends to focus on some of the ideas drawn from this research. The
Company will also continue to exploit initiatives which were begun in 1997 that
have required some time to be fully implemented, such as the offering of the
Company's products in the official Boy Scout catalog.

The sales of the Company are not seasonal. Sales were down approximately
10% in the fourth quarter of 1997 from the same period in 1996 and were down
rather uniformly throughout the year. It is clear that the Company is in a
protracted down cycle in the craft and western markets. The majority of the
Company's management team has experienced similar downturns twice before in
their careers. Through new product introduction and attentiveness to customer
needs and desires, the Company plans to offset any further losses in sales and
position itself to take full advantage of opportunities as conditions in these
markets improve.

Costs, Gross Profit, and Expenses

Cost of sales as a percentage of revenue was 58.4% for 1997 as compared to
62.6% for 1996. The difference in the relative cost of sales percentage was
principally attributable to: (i) a change in sales mix, in that the percentage
of the Company's sales reflecting relative lower costs of sales increased; (ii)
management's plan to raise prices and selectively eliminate lower margin items
from the Company's product lines; and (iii) direct labor costs that were
eliminated due to planned personnel reductions and the settlement of the labor
dispute at Cushman in October of 1996.

A lower relative cost of sales percentage meant that gross profit as a
percentage of sales was higher for the year ended December 31, 1997 compared to
1996. Gross profit as a percentage of sales increased 4.2 percentage points to
41.6% in 1997 from 37.4% in 1996. Due to the factors mentioned above relative to
cost of sales, the Company generated almost the same amount of gross profit in
dollars on $25,399,116 in sales during the year ended December 31, 1997 as it
did on $28,253,632 in sales during 1996.

12

Operating expenses decreased $1,503,686 or 13.8% to $9,365,673 during 1997
from $10,869,359 in 1996. This decrease in operating expenses was the net result
of cost control measures instituted by management.

The specific reductions in operating expenses involved several factors,
including the following significant elements: (i) reduced payroll, payroll tax
and payroll related expenses of approximately $500,000 due to a substantially
lower average number of employees during 1997 compared to 1996; (ii) a small bad
debt recovery was recorded during 1997 as opposed to $229,000 of expense for
1996, principally due to $120,665 in bad debt expense because of a significant
customer declaring Chapter 11 bankruptcy during 1996; (iii) a net reduction in
commission expense of $151,183 occurred in 1997, due primarily to the
elimination of sales representatives in the retail craft market partially offset
by an increase of $19,052 in commissions paid at Cushman attributable to the
Company's line of finished leather goods; (iv) $140,772 less amortization
expense was recorded in 1997 as opposed to 1996, principally because of the
write down of certain purchased goodwill during 1996; and (iv) reductions of
$50,000 or more in each of advertising, corporate fees and shareholders
relations, freight, insurance, supplies, travel, and marketing samples. These
decreases in operating expenses were partially offset by increased professional
expenses incurred by the Company in initial efforts to obtain new financing
during 1997.

Other (Income) Expense

Other expenses were $887,543 for the year ended December 31, 1997 compared
to $1,000,604 during the same period in 1996. The difference between the two
years involved decreased interest expense. The difference in the dollar amount
of interest expense was principally due to the write-off in 1996 of the
commitment and facility fees attributable to the acquisition commitments that
expired in July 1996. The interest expense that the Company could have saved
during 1997 from decreased levels of debt compared to the previous year, was
offset by increased interest rates and the forbearance fees charged by
NationsBank. Due to the Company's continuing default under certain covenants
contained in the NationsBank debt facility, the rate of interest charged by
NationsBank increased from an average of the Prime Rate or less during the prior
fiscal year to the Prime Rate plus 2% on average for 1997.

Provision (Benefit) for Income Taxes

The provision for federal and state income taxes was 77% of 1997 income
before taxes due to certain non-deductible expenses totaling $235,000,
principally comprised of the amortization of goodwill. Taking this into account
the Company's effective tax rate materially approximates the Company's
historical rate for combined federal and state income taxes of about 40%.

Net Income

The Company recorded net income of $70,292 for 1997 as compared to
reporting a net loss of $989,768 during 1996. The change in results was
primarily due to the factors noted above regarding sales, cost of goods sold,
operating expenses and other (income) expense.

Analysis of 1996 Compared to 1995

Revenues

The Company's net sales decreased by 10.2% to $28,253,632 during 1996 from
$31,447,849 in 1995. The 10.2% decrease in revenues was primarily comprised of
two pieces. Reduced sales to the retail craft industry comprised 7.7% and
reduced sales at Cushman comprised 2.7%. The Company's sales to the retail craft
industry and its sales at Cushman during 1996 were negatively impacted by
challenging retail environments in the craft and western markets.

Costs, Gross Profit, and Expenses

Cost of sales as a percentage of revenue was 62.6% for 1996 as compared to
58.7% for 1995. The difference in the relative cost of sales percentage was
principally attributable to a change in sales mix, price competition in a very
competitive market environment and direct labor costs associated with the labor
dispute at Cushman.

13

Operating expenses increased $506,200 or 4.9% to $10,869,359 during 1996
from $10,363,159 during 1995. The increase in operating expenses between the two
periods was due to various factors, including (i) an increase in bad debt
expense of $120,665 because of a significant customer declaring Chapter 11
bankruptcy, (ii) expenses associated with two new locations, (iii) write down of
certain purchased goodwill due to its impairment, (iv) increased advertising
expense to generate new sales and (v) an increase in operating expenses at
Cushman, some of which were related to previous labor problems. These increases
in operating expenses were partially offset by lower discretionary bonuses and
commissions.

Other (Income) Expense

Other expenses were $1,000,604 for 1996 as compared to $678,264 during
1995. This increase was primarily due to the write-off of the commitment and
facility fees attributable to the acquisition financing commitments which
expired in July 1996, and an increase in interest expense due to an increase in
the outstanding balance on the working capital line of credit.

Provision (Benefit) for Income Taxes

The benefit for income taxes was 24% of the loss before income taxes in
1996, as compared to a provision for income taxes of 40% of income before taxes
in 1995. This difference is primarily a result of an increase in the
amortization of non-deductible goodwill.

Net Income

The Company incurred a net loss of $989,768 for 1996 as compared to
reporting net income of $1,173,304 during 1995. The loss was primarily due to
the factors noted above regarding sales, cost of goods sold, operating expenses
and other (income) expense.

Capital Resources and Liquidity

The primary sources of liquidity and capital resources during 1997 were
borrowings on the Company's credit facility with NationsBank, the Senior Debt
Facility with FINOVA and the Subordinated Debenture with Schlinger, and cash
flows provided by operating activities.

While having a negative impact on sales, the Company's focus in 1997 on
improving gross profit margins and reducing operating expenses was effective as
indicated by the strong cash flows from operations in the amount of $1,605,305.
The use of cash flows from operations to pay down debt is reflected in the
improvement of the Company's debt to equity ratio from 1.07 at December 31, 1996
to 0.89 at December 31, 1997.

Some of this improvement in cash flow resulted from the Company's ability
to reduce its investment in accounts receivable and inventory given the reduced
level of sales. Accounts receivable decreased to $1,865,276 and inventory
decreased to $7,279,702 at December 31, 1997 from $1,947,698 and $7,737,320,
respectively, at December 31, 1996. The aging of accounts receivable has not
deteriorated and is indicative of managements' continued tight credit and
collection policies which have also contributed to the negative trend in sales
noted above.

Even at the reduced level, inventory only turned 1.98 times during 1997,
which is below the 1996 ratio of 2.26 times. This decrease in the turn rate
indicates that further reductions in inventory are still needed as of December
31, 1997 for the current level of sales. Management anticipates the
implementation of new information systems will assist in monitoring of inventory
levels in 1998.

The refinancing of the Company's debt on a long-term basis (as discussed in
Item 1 and Note 3 to the Consolidated Financial Statements) improved the
Company's financial position substantially. For example, the Company's monthly
debt service requirements are approximately $30,000 less than under the
Company's prior arrangements. As discussed in Note 3, the revolving credit
portion of the Senior Debt Facility ($4,030,519 at December 31, 1997) is shown
as current because of an accounting requirement when the revolving credit
agreement contains both a subjective acceleration clause and a requirement for
an arrangement whereby cash collections directly reduce the debt outstanding.
Management does not believe that any such acceleration will occur and absent
such required classification, the Company's current ratio would have been 4.86
at December 31, 1997 compared to 1.13 at the end of 1996.

14

The Senior Debt Facility is now comprised of a revolving credit facility
("Revolving Credit Loan") and two term notes. The revolving portion is based
upon the level of the Company's accounts receivable and inventory. At December
31, 1997, the Company had additional availability on the revolving credit
facility of approximately $377,000. As the Company's sales and operations expand
requiring larger investments in accounts receivable and inventory, the Company
could have almost $3,000,000 in additional funds available under the Revolving
Credit Loan.

The largest use of cash beyond debt payments in 1997 was for capital
expenditures. Cash used for capital expenditures totaled $239,578 and $208,537
for the years ended December 31, 1997 and 1996, respectively. The 1997
expenditures principally relate to the new computer system presently being
installed and implemented, with the 1996 amounts relating to: (i) new equipment
acquired to open the Charlotte, NC sales/distribution unit; (ii) new equipment
for the Fort Worth manufacturing facility; and (iii) the purchase of various
equipment, office furniture and fixtures. The Company received proceeds of
$257,306 in 1997 from the sale of the Company's land and building located in
Tampa, Florida. The Company now leases the site for its sales/distribution unit
in Tampa, Florida.

The Company believes that the current sources of liquidity and capital
resources will be sufficient to fund current operations and the opening of new
sales/distribution units. In 1998, the funding for the opening of new units is
expected to be provided by operating leases, cash flows from operating
activities, and the Company's Revolving Credit Loan with FINOVA.

The Company's new financings with both FINOVA and Schlinger mature on
December 1, 1999 and management intends to pursue negotiations with FINOVA and
other potential lenders in late 1998 and early 1999 to extend or replace the
maturing notes. Management believes it will be able to secure the required
financing prior to the maturity of these loans. However, in the event of a
future material adverse change in the Company's operations, FINOVA could
accelerate their debt or otherwise determine not to renew the notes. In such a
circumstance, the Company would pursue other sources of financing. If other
financing could not be secured, the Company could experience a material adverse
impact.

Management perceives opportunities to acquire related business in the
marketplace due to the fragmented nature of the markets in which the Company
conducts business as well as due to the competitive conditions of these markets.
The Company's present financing arrangements will not be sufficient to make
these acquisitions and if any acquisitions are to be consummated, the Company
will be required to obtain additional debt or equity financing. Any new
financings will require the consent of FINOVA. The Company can provide no
assurance that these acquisitions can be made on terms acceptable to the Company
or that the needed financings to enter into these transactions can be obtained.

Year 2000 Issue

The Company has developed a plan to modify its information technology to be
ready for the year 2000 and has begun converting critical data processing
systems. At December 31, 1997, the majority of systems had been converted with
total cost to date of less than $100,000. The Company does not expect this
project to have a significant effect on operations nor any material remaining
costs to be incurred.

15

Cautionary Statement

The disclosures under "-Results of Operations"; "-Capital Resources and
Liquidity"; "Year 2000 Issue" and in the Notes to Consolidated Financial
Statements as provided elsewhere herein contain forward-looking statements and
projections of management. There are certain important factors which could cause
results to differ materially than those anticipated by some of the
forward-looking statements. Some of the important factors which could cause
actual results to differ materially from those in the forward-looking statements
include, among other things, changes from anticipated levels of sales, whether
due to future national or regional economic and competitive conditions,
including, but not limited to, retail craft buying patterns, and possible
negative trends in the craft and western retail markets, customer acceptance of
existing and new products, or otherwise, pricing pressures due to competitive
industry conditions, increases in prices for leather, which is a world-wide
commodity, which for some reason, may not be passed on to the customers of the
Company's products, change in tax rates, change in interest rates, change in the
commercial banking environment, problems with the importation of the products
which the Company buys in 14 countries around the world, including, but not
limited to, transportation problems or changes in the political climate of the
countries involved, including the maintenance by said countries of Most Favored
Nation status with the United States of America, and other uncertainties, all of
which are difficult to predict and many of which are beyond the control of the
Company.

Item 8. Financial Statements and Supplementary Data.

The Financial Statements and Financial Statement Schedule are filed as a
part of this report. See page 17, Index to Consolidated Financial Statements.

Item 9. Change In and Disagreements with Accountants on Accounting and
Financial Disclosure.

None.

16

THE LEATHER FACTORY, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Consolidated Balance Sheets at December 31, 1997 and 1996.................................................18

Consolidated Statements of Income For the Years Ended December 31, 1997, 1996 and 1995....................19

Consolidated Statements of Cash Flows For the Years Ended December 31, 1997, 1996 and 1995................20

Consolidated Statements of Stockholders' Equity For the Years Ended December 31, 1997, 1996 and 1995......21

Notes to Consolidated Financial Statements................................................................22-31

Financial Statement Schedules for the years ended December 31, 1997 and 1996:

II -- Valuation and Qualifying Accounts and Reserves.................................................32

All other schedules are omitted since the required information is not
present or is not present in amounts sufficient to require submission of the
schedule or because the information required is included in the consolidated
financial statements and notes thereto.

Reports of Independent Auditors...........................................................................33-34

17

THE LEATHER FACTORY, INC.
CONSOLIDATED BALANCE SHEETS
December 31, 1997 AND 1996

1997 1996
-------------- --------------
ASSETS
CURRENT ASSETS:
Cash $ 70,496 $ 488,192
Cash restricted for payment on revolving credit facility 319,133 -
Accounts receivable-trade, net of allowance for
doubtful accounts of $28,000 and $54,000
in 1997 and 1996, respectively 1,865,276 1,947,698
Inventory 7,279,702 7,737,320
Prepaid income taxes 285,970 538,458
Deferred income taxes 109,411 126,955
Other current assets 385,199 542,809
-------------- --------------
Total current assets 10,315,187 11,381,432
-------------- --------------

PROPERTY AND EQUIPMENT, at cost 2,534,839 2,672,253
Less: accumulated depreciation and amortization (1,505,098) (1,273,609)
-------------- --------------
Property and equipment, net 1,029,741 1,398,644

GOODWILL and other, net of accumulated amortization of
$878,000 and $660,000 in 1997 and 1996, respectively 5,679,621 5,484,471
-------------- --------------
$ 17,024,549 $ 18,264,547
============== ==============

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 942,046 $ 940,549
Accrued expenses and other liabilities 559,776 597,007
Notes payable and current maturities of
long-term debt 4,650,742 8,549,366
-------------- --------------
Total current liabilities 6,152,564 10,086,922
-------------- --------------

DEFERRED INCOME TAXES 136,611 137,310

NOTES PAYABLE AND LONG-TERM DEBT,
net of current maturities 2,602,728 17,378

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
Preferred stock, $0.10 par value; 20,000,000
shares authorized, none issued or outstanding - -
Common stock, $0.0024 par value; 25,000,000 shares
authorized, 9,853,161 shares issued in 1997 and 1996 23,648 23,648
Paid-in capital 4,119,915 4,130,796
Retained earnings 4,534,569 4,464,277
Less: Notes receivable - secured by common stock (257,617) (269,305)
Cumulative translation adjustments (14,018) (295)
Less: Unearned shares held by ESOP, 54,262 and
64,631 shares in 1997 and 1996, respectively (273,851) (326,184)
-------------- --------------
Total stockholders' equity 8,132,646 8,022,937
-------------- --------------
$ 17,024,549 $ 18,264,547
============== ==============

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

18

THE LEATHER FACTORY, INC.
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

1997 1996 1995
-------------- -------------- --------------

NET SALES $ 25,399,116 $ 28,253,632 $ 31,447,849

COST OF SALES 14,844,376 17,689,973 18,446,378
-------------- -------------- --------------

Gross profit 10,554,740 10,563,659 13,001,471

OPERATING EXPENSES 9,365,673 10,869,359 10,363,159
-------------- -------------- --------------

INCOME (LOSS) FROM OPERATIONS 1,189,067 (305,700) 2,638,312

OTHER (INCOME) EXPENSE:
Interest expense 867,548 1,007,544 718,066
Other, net 19,995 (6,940) (39,802)
-------------- -------------- --------------
Total other (income) expense 887,543 1,000,604 678,264
--------------- -------------- --------------

INCOME (LOSS) BEFORE INCOME TAXES 301,524 (1,306,304) 1,960,048

PROVISION (BENEFIT) FOR INCOME TAXES 231,232 (316,536) 786,744
--------------- -------------- --------------

NET INCOME (LOSS) $ 70,292 $ (989,768) $ 1,173,304
============== ============== ==============

EARNINGS (LOSS) PER COMMON SHARE $ .01 $ (0.10) $ 0.12
=============== ============== ==============

EARNINGS (LOSS) PER COMMON SHARE--Assuming Dilution $ .01 $ (0.10) $ 0.12
=============== ============== ==============

DIVIDENDS PAID PER COMMON SHARE $ - $ - $ -
============== ============== ==============

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

19

THE LEATHER FACTORY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

1997 1996 1995
-------------- --------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 70,292 $ (989,768) $ 1,173,304
Adjustments to reconcile net income to net
cash provided by (used in) operating activities-
Depreciation and amortization 523,551 638,450 424,135
(Gain) loss on sales of assets 46,950 (7,541) (9,524)
Deferred financing costs 32,113 156,891 -
Deferred income taxes 16,845 13,479 (9,257)
Other 1,150 785 -
Net changes in operating assets and liabilities, net of effect of
acquisitions:
Accounts receivable-trade, net 82,422 814,870 (104,118)
Inventory 457,618 241,843 328,316
Income taxes 252,488 (383,199) (243,435)
Other current assets 157,610 130,683 (326,759)
Accounts payable 1,497 (458,368) (104,939)
Accrued expenses and other liabilities (37,231) (58,482) (400,868)
-------------- --------------- --------------
Total adjustments 1,535,013 1,089,411 (446,449)
-------------- --------------- --------------

Net cash provided by operating activities 1,605,305 99,643 726,855
-------------- --------------- --------------

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (239,578) (208,537) (513,483)
Proceeds from sales of assets 257,306 10,444 17,746
Cash paid for acquisitions, net of cash acquired - (300,000) (5,232,389)
Decrease in assets restricted for acquisitions - - 5,040,656
Other intangible costs (32,061) (24,788) (42,234)
-------------- --------------- --------------

Net cash used in investing activities (14,333) (522,881) (729,704)
-------------- --------------- --------------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from notes payable and long-term debt 9,859,025 3,300,000 2,574,904
Payments on notes payable and long-term debt (11,410,299) (2,596,424) (2,231,478)
Increase in cash restricted for payment on revolving credit facility (319,133) - -
Payments received (purchase) of notes receivable -
secured by common stock 11,688 (269,305) -
Securities acquisition loan to ESOP - - (99,962)
Deferred financing costs (149,949) - (165,709)
-------------- --------------- --------------

Net cash provided by (used in) financing activities (2,008,668) 434,271 77,755
-------------- --------------- --------------

NET INCREASE (DECREASE) IN CASH (417,696) 11,033 74,906

CASH, beginning of year 488,192 477,159 402,253
-------------- --------------- --------------

CASH, end of year $ 70,496 $ 488,192 $ 477,159
============== =============== ==============

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid during the year $ 749,472 $ 793,373 $ 763,848
Income taxes paid during the year, net of (refunds) (38,101) 55,445 1,066,111

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

20

THE LEATHER FACTORY, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995

Common Stock
Notes
------------------------ receivable Cumulative
Number Par Paid-in Retained - secured by translation Unearned
of shares value capital earnings common stock adjustments ESOP shares Total
----------- ----------- ------------ ------------ ------------- ------------ ----------- -----------

BALANCE, December 31, 1994 9,853,161 $ 23,648 $ 4,139,614 $ 4,280,741 $ - $ - $(226,222) $ 8,217,781

Stock issuance costs - - (8,818) - - - - (8,818)

Securities acquisition
loan to ESOP - - - - - - (99,962) (99,962)

Net income - - - 1,173,304 - - - 1,173,304
--------- --------- ------------ ------------ ------------ ------------ ----------- -----------

BALANCE, December 31, 1995 9,853,161 23,648 4,130,796 5,454,045 - - (326,184) 9,282,305

Notes receivable - secured
by common stock - - - - (269,305) - - (269,305)

Translation adjustment - - - - - (295) - (295)

Net loss - - - (989,768) - - - (989,768)
--------- ----------- ------------ ------------ ------------ ------------ ---------- -----------

BALANCE, December 31, 1996 9,853,161 23,648 4,130,796 4,464,277 (269,305) (295) (326,184) 8,022,937

Payments on notes receivable -
secured by common stock - - - - 11,688 - - 11,688

Allocation of suspended ESOP
shares committed to be released - - (45,881) - - - 52,333 6,452

Warrants issued to acquire
100,000 shares of common stock - - 35,000 - - - - 35,000

Translation adjustment - - - - - (13,723) - (13,723)

Net income - - - 70,292 - - - 70,292
--------- ----------- ------------ ------------ ------------- ------------ ----------- ----------

BALANCE, December 31, 1997 9,853,161 $ 23,648 $ 4,119,915 $ 4,534,569 $ (257,617) $(14,018) $(273,851) $8,132,646
========= =========== ============ =========== ============= ============ =========== ==========

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

21

THE LEATHER FACTORY, INC.
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

DECEMBER 31, 1997, 1996 AND 1995

1. ORGANIZATION AND NATURE OF OPERATIONS

The Leather Factory, Inc. and subsidiaries (the "Company") operations include
the manufacture, distribution, importation, and exportation of leather,
leatherworking tools, buckles and other belt supplies, shoe care and repair
supplies, leather dyes and finishes, adornments for belts, bags, and garments,
saddle and tack hardware, and do-it-yourself kits. The Company through its
subsidiary, Roberts, Cushman & Company, Inc., is also a manufacturer and
distributor of hat trims and small finished leather goods such as cigar cases,
picture frames, wallets, and western accessories. As of December 31, 1997, the
Company had 22 sales/distribution units in 17 states and Canada, including
Arizona, California, Colorado, Florida, Iowa, Kansas, Louisiana, Michigan,
Missouri, New Mexico, North Carolina, Ohio, Pennsylvania, Tennessee, Texas,
Utah, Washington, and Winnipeg. The Company also has light manufacturing
facilities In Fort Worth, Texas and New York, New York.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation

The consolidated financial statements include the accounts of the Company and
its subsidiaries, all of which are wholly-owned. Significant intercompany
accounts and transactions have been eliminated in consolidation.

Inventory

The Company's inventory is valued at the lower of first-in, first-out cost or
market and consists of the following at December 31:

1997 1996
---------- ----------
Finished goods held for sale $5,833,002 $6,516,517
Raw materials and work in process 1,446,700 1,220,803
---------- ----------
$7,279,702 $7,737,320
========== ==========

Property and Equipment

Property and equipment are stated at cost. Expenditures for maintenance and
repairs are charged to expense when incurred. The cost of assets retired or sold
and the related amounts of accumulated depreciation are removed from the
accounts, and any gain or loss is included in the statement of income.
Depreciation is determined using the straight-line method over the estimated
useful lives as follows:

Building 30 years
Leasehold improvements 5-7 years
Equipment 5-10 years
Furniture and fixtures 5-7 years
Automobiles 5 years

Depreciation expense was $303,867; $277,994; and 224,364 for the years ended
December 31, 1997, 1996 and 1995, respectively.

Goodwill

Goodwill resulting from business purchases accounted for using the purchase
method of accounting is being amortized on a straight-line basis over estimated
useful lives ranging from ten to forty years.

Acquisitions to date have not involved any significant long-lived assets other
than goodwill. Accordingly, the Company evaluates such goodwill for impairment
in accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 17, "Intangible Assets." During 1996, the Company determined that the
goodwill associated with the acquisition of Hi-Line Leather and Manufacturing
Co., Inc. in 1994 was impaired, and should be reduced by fifty percent or
approximately $142,000. This conclusion was reached due to the fact that the
customer base acquired in the purchase transaction had declined substantially,
and the operating results of the location since the acquisition had not met
expectations. Based upon the assessment of possible future cash flows and the
fact that business conditions could improve, management believes the remaining
goodwill is recoverable and the amortization period remains appropriate.

22

Amortization expense of $219,684 in 1997; $360,456 in 1996; and $199,771 in 1995
was recorded in operating expenses including the above write-down.

Advertising Costs

With the exception of catalog costs, advertising cost are expensed as incurred.
Catalog costs are capitalized and expensed over the estimated useful life of the
particular catalog in question, which is typically twelve to fifteen months.
Such capitalized costs are included in other current assets and totaled $39,350
and $203,755 at December 31, 1997 and 1996, respectively. Total advertising
expense was $1,002,623 in 1997; $1,089,716 in 1996; and $976,126 in 1995.

Revenue Recognition

Sales are recorded when goods are shipped to customers.

Income Taxes

Deferred income taxes result from temporary differences in the basis of assets
and liabilities reported for financial statement and income tax purposes.

Earnings Per Share

In 1997, the Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standards ("SFAS") No. 128, Earnings per Share. SFAS No.
128 replaced the calculation of primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share excludes any dilutive effects of options, warrants and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented to conform to Statement 128
requirements. The adoption of Statement 128 had no effect on previously reported
amounts as the effects of outstanding options were antidilutive for all prior
periods presented. Unearned shares held by the Employees' Stock Ownership Plan
are deemed not to be outstanding for earnings per share calculations.

Accounting Estimates

The consolidated financial statements include estimates and assumptions made by
management that affect the reported amounts of assets and liabilities, the
reported amounts of revenues and expenses and the disclosure of contingent
assets and liabilities.
Actual results could differ from those estimates.

Long-Lived Assets

The FASB has issued SFAS No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of. SFAS No. 121 requires that
long-lived assets and certain identifiable intangible assets be reviewed for
impairment whenever events indicate that the carrying amount of an asset may not
be recoverable. The Company has determined that as of December 31, 1997, it has
no long-lived assets that meet the impairment criteria of SFAS No. 121.

Stock-Based Compensation

SFAS No. 123, Accounting for Stock-Based Compensation, establishes financial
accounting and reporting standards for stock-based employee compensation plans.
As permitted by SFAS 123, the Company has elected to continue to use Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB 25") and related Interpretations, in accounting for its stock option
plans.

Impact of new accounting standards

In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income, and
SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information. SFAS No. 130 requires that an enterprise report, by major component
and as a single total, the change in its equity during the period from nonowner
sources, and SFAS No. 131 establishes annual and interim reporting requirements
for an enterprise's operating segments and related disclosures about its
products and services, geographical areas in which it operates and major
customers. Both statements are effective for fiscal years beginning after
December 15, 1997, with earlier application permitted. Adoption of these
statements is not expected to materially impact the Company's consolidated
financial position or statements of income, stockholders' equity and cash flows.
Effects of the adoption of these statements will primarily be limited to the
form and content of the Company's disclosures.

23

3. NOTES PAYABLE AND LONG-TERM DEBT

On November 21, 1997, the Company entered into a Loan and Security Agreement
with FINOVA Capital Corporation ("FINOVA"), pursuant to which FINOVA agreed to
provide a credit facility of up to $9,136,000 in senior debt (the "Senior Debt
Facility"). The Senior Debt Facility has a two-year term and is made up of a
revolving credit facility and three term notes. One of the notes (Term Note B)
in the original principal amount of $236,000 was satisfied in its entirety on
December 15, 1997 with the net proceeds from the sale of the real estate in
Tampa, Florida.

Simultaneously with the closing of the Senior Debt Facility the Company also
issued to The Schlinger Foundation at face value $1,000,000 in subordinated
convertible debt (the "Subordinated Debenture").

Proceeds of the closing of the Senior Debt Facility in the amount of $6,417,563,
together with the $1,000,000 of proceeds from the Subordinated Debenture, were
used to pay all amounts due and owing by the Company pursuant to the Second
Restated Loan Agreement, as amended, by and between the Company and NationsBank
of Texas, N.A. ("NationsBank"). At closing, the Company's revolving line of
credit and term loan facility with NationsBank in the principal amounts of
$5,125,000 and $2,200,000, respectively, were satisfied in their entirety. The
Company used the remaining proceeds to pay certain closing and financing costs.

At December 31, 1997 and 1996, the amounts outstanding under the above
agreements and other notes payable and long-term debt consisted of the
following:

1997 1996
---- ----
Loan & Security Agreement with FINOVA -- collateralized by all of the assets of
the Company as well as a pledge of 3,000,000 shares of the Company's common
stock, par value $.0024 ("Common Stock"), collectively owned by two of the
Company's executive officers, payable as follows:

Promissory Note (Revolving Credit Loan) dated November 21, 1997 in the
maximum principal amount of $7,000,000 with revolving features as more
fully described below -- interest due monthly at prime plus 1% (9.5% at
December 31, 1997); matures December 1, 1999 $ 4,030,519 $ -

Promissory Note (Term Loan A) dated November 21, 1997 in the original
principal amount of $400,000 -- $6,667 monthly principal payments plus
interest at prime plus .75% (9.25% at December 31, 1997); matures
December 1, 1999 400,000 -

Promissory Note (Term Loan C) dated November 21, 1997 in the original
principal amount of $1,500,000 -- $25,000 monthly principal payments
plus interest at prime plus 3% (11.5% at December 31, 1997); matures
December 1, 1999 1,500,000 -

*Short-term note payable for facility fee -- monthly installments of
$5,833; matures November 1, 1998 64,167 -

*Unsecured short-term note payable to third party for fees in connection with
the closing of the Senior Debt facility -- monthly installments of $14,000;
matures October 1, 1998 140,000 -

Loan Agreement with NationsBank -- collateralized by inventory, trade accounts
receivable, equipment, fixtures and real estate, payable as follows:

Promissory Note (Term Loan) dated December 28, 1994 in the original
principal amount of $5,000,000 -- $250,000 principal due quarterly with
monthly interest payments at prime plus 1.5% (9.75% at December 31, 1996)
until maturity at April 30, 1997; maturity was extended to
November 30, 1997 with the rate increased to prime plus 2% - 3,000,000

Promissory Note (Working Capital Line of Credit) originally dated July 24,
1995 in the maximum principal amount of $6,500,000 -- interest due monthly
at prime plus 1.5 % (9.75% at December 31, 1996) until maturity at April
30, 1997; maturity was extended to November 30, 1997 with the
rate increased to prime plus 2% - 5,500,000

24

Subordinated Debenture in the original principal amount of $1,000,000; partially
convertible; secured by a pledge of 2,666,666 shares of the Company's Common
Stock owned by another executive officer -- monthly interest payments at 13%;
matures December 1, 1999; 1,000,000 -

Unsecured note payable created in connection with the acquisition of the assets
of The Leather Warehouse in 1994 -- $4,424 payments of principal and interest
due monthly at prime (8.5% at December 31, 1997); matures on April 1, 1998 17,388 66,744

Capital Leases secured by computer equipment -- total monthly principal and
interest payments of $2,599 at a rate of approximately 13.5%; maturing in
February through August of 2002 101,396 -

------------- ----------
7,253,470 8,566,744

Less - Current maturities (see below) 4,650,742 8,549,366
------------- ----------
$ 2,602,728 $ 17,378
============= ==========

The current portion of long-term debt for 1997 includes the FINOVA Revolving
Credit Loan of $4,030,519 although this obligation does not mature until
December 1, 1999. The classification of this debt was attributed to an
accounting rule that requires a revolving credit agreement that includes both a
subjective acceleration clause and a requirement to maintain an arrangement,
whereby cash collections from the borrower's customers directly reduce the debt
outstanding, to be classified as a short-term obligation (Emerging Issues Task
Force Issue 95-22). A covenant of the Senior Debt Facility is that collections
from customers are to be deposited into a cash collateral account that directly
pays down the Revolving Credit Loan. The balance in this account comprises the
restricted cash on the Company's balance sheet. Because of this arrangement and
the fact that the debt agreement contains a clause that would allow acceleration
of payment of the debt in case of a "material adverse change", the above rule
applies. Management does not believe that any such acceleration will occur and
that the Revolving Credit Loan will provide long-term liquidity.

In addition to the above obligations, the Company had outstanding letters of
credit for inventory purchase commitments with terms ranging from sight to 90
days. As of December 31, 1997 and 1996, $260,089 and $273,065, respectively,
were outstanding on these letters of credit.

Pursuant to the Loan and Security Agreement with FINOVA, the overall combined
limit for borrowings under the Revolving Credit Loan and outstanding balance on
letters of credit is $7,000,000. Of the overall $7,000,000 limit, letters of
credit cannot exceed $1,000,000. The unused portion of the letter of credit
limit can be utilized for borrowings, up to the limits imposed for said
indebtedness. Total borrowings under this arrangement are also limited to a
certain percentage of trade accounts receivable and inventory reduced by the
outstanding balance of letters of credit and any required reserves. Additional
availability at December 31, 1997, under the Revolving Credit Loan and for
letters of credit was $377,831.

At any time before maturity of the Subordinated Debenture, the holder may, at
its option, satisfy 50% or $500,000 of the principal amount by converting into
shares of the Company's Common Stock at $0.724 per share.

The terms of the Senior Debt Facility and the Subordinated Debenture contain
various covenants which among other things require the Company to maintain a
certain level of earnings before interest, taxes, depreciation and amortization,
limit capital expenditures, and require the maintenance of certain debt service
coverage ratios. Other covenants prohibit the Company from incurring
indebtedness except as permitted by the terms of the Senior Debt Facility, from
declaring or paying cash dividends upon any of its stock and from entering into
any new business or making material changes in any of the Company's business
objectives, purposes or operations.

The Company's notes payable and long-term debt mature as follows (see discussion
above relative to classification of the Revolving Credit Loan):

1998 $ 4,650,742
1999 2,541,338
2000 24,393
2001 31,132
2002 5,865
------------
$ 7,253,470
============

*The short-term notes for the fees related to the closing of the Senior Debt
Facility were issued for services rendered in the original amount of $238,000
and constitute a non-monetary transaction.

25

4. EMPLOYEE BENEFIT PLAN

The Company has an Employee Stock Ownership Plan (the "Plan") for employees with
at least one year of service (as defined by the Plan) and who have reached their
21st birthday. Under the Plan, the Company makes annual cash or stock
contributions to a trust for the benefit of eligible employees. The trust
invests in shares of the Company's common stock. The amount of the Company's
annual contribution is discretionary. Benefits under the Plan are 100% vested
after three years of service and are payable upon death, disability or
retirement. Vested benefits are payable upon termination of employment.

The Company contributed $50,910; $27,500; and $133,378 in cash to the Plan
during 1997, 1996 and 1995, respectively. Of the 1995 amount, $33,416
represented a contribution, while $99,962 represented a securities acquisition
loan. During 1995, the Plan purchased 23,500 shares of Company stock on the open
market for $99,962. In accordance with Statement of Position 93-6 ("SOP 93-6"),
"Employers Accounting for Employee Stock Ownership Plans," shares purchased with
loan proceeds have been recorded as unearned ESOP shares. The unearned ESOP
share account is reduced by the cost of the shares when they are committed to be
released to participants. This occurs as payments are made on the loans using
the principal and interest method and shares are allocated to participant
accounts based upon eligible compensation during the period that includes the
scheduled payment. During 1997, 10,369 shares were released and allocated to
participant accounts. Compensation expense is measured using the average fair
market value of the shares when committed to be released. The Company recognized
compensation expense related to the Plan of $53,968; $27,500; and $33,416 in
1997, 1996 and 1995, respectively.

The following table summarizes the number of shares held by the Plan and the
market value as of December 31, 1997, 1996 and 1995:

No. of Shares Market Value
------------- ------------
1997 1996 1995 1997 1996 1995
----- ---- ---- ---- --- ----
Allocated 652,609 681,547 725,605 $ 326,305 $ 554,098 $ 1,769,025
Unearned 54,262 64,631 64,631 27,131 52,545 157,570
-------------------------- -----------------------------------
Total 706,871 746,178 790,236 $ 353,436 $ 606,643 $ 1,926,595
========================== ===================================

The Company currently offers no postretirement or postemployment benefits to its
employees.

5. INCOME TAXES

The provision for income taxes consists of the following:

1997 1996 1995
---- ---- ----
Current provision (benefit):
Federal $ 174,469 $ (282,917) $ 658,975
State 39,918 (47,098) 137,026
---------- ----------- ----------
214,387 (330,015) 796,001
---------- ----------- ----------
Deferred provision (benefit):
Federal 14,185 11,351 (7,870)
State 2,660 2,128 (1,387)
---------- ------------ ----------
16,845 13,479 (9,257)
---------- ------------ ----------
$ 231,232 $ (316,536) $ 786,744
========== =========== ==========

Deferred taxes relate primarily to temporary differences in the bases of
accounts receivable, inventory, property and equipment and accrued expenses.

The effective tax rate differs from the statutory rate as follows:

1997 1996 1995
---- ---- ----
Statutory rate 34% (34%) 34%
State taxes 10% (3%) 4%
Non-deductible goodwill amortization 26% 10% 4%
Other 7% 3% (2%)
---------------------
Effective rate 77% (24%) 40%
======================

26

6. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company's primary office facility and warehouse are leased under a five-year
lease agreement that expires in March 2003. Rental agreements for the
sales/distribution units expire on dates ranging from July 31, 1998 to December
31, 2003. The Company's lease agreement for the manufacturing facility in New
York, New York, expires on September 30, 1998. Future minimum lease payments for
all noncancellable operating leases are as follows:

Year Ending December 31,

1998 $ 994,244
1999 742,224
2000 590,443
2001 486,891
2002 384,684
2003 and thereafter 117,431
------------
Total future minimum lease payments $ 3,315,917
============

Rent expense on all operating leases for the years ended December 31, 1997, 1996
and 1995, was $1,036,892; $1,008,458; and $928,433, respectively.

Litigation

The Company has litigation in the ordinary course of its business and
operations. The Company does not expect the outcome of any current litigation to
have a material impact on its financial position and results of operations.

7. MAJOR VENDORS

Two major vendors accounted for 17% and 8%, respectively, of the Company's 1997
inventory purchases. These same vendors accounted for 16% and 10%, respectively,
of 1996 inventory purchases, and 15% and 14%, respectively, of 1995 inventory
purchases. Due to the number of alternative sources of supply, it is
management's opinion that the loss of either or both of these principal
suppliers would not have a material impact on the operations of the Company.

8. EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per
share:

1997 1996 1995
---------------- ---------------- ----------------
Numerator:
Net income (loss) $ 70,292 $ (989,768) $ 1,173,304
---------------- ---------------- ----------------
Numerator for basic and diluted
earnings per share 70,292 (989,768) 1,173,304

Denominator:
Denominator for basic earnings per share-
weighted-average shares 9,789,358 9,788,530 9,789,468

Effect of dilutive securities:
Employee stock options 25 - -
Warrants 2,182 - -
---------------- ---------------- ----------------
Dilutive potential common shares 2,207 - -
---------------- ---------------- ----------------

Denominator for diluted earnings per share -
adjusted weighted-average shares and assumed
conversions 9,791,565 9,788,530 9,789,468
================ ================ ================

Basic earnings per share $ 0.01 $ (0.10) $ 0.12
================ ================ ================

Diluted earnings per share $ 0.01 $ (0.10) $ 0.12
================ ================ ================

27

For additional disclosures regarding the employee stock options and the
warrants, see note 9. The majority of the options outstanding as discussed in
note 9 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 and, therefore, the effect would be antidilutive.

The 13% convertible debt discussed in note 3 above was not included in the
computation of diluted earnings per share because the interest cost (net of tax)
per assumed converted share was more than basic earnings per share and,
therefore, the effect would be antidilutive.

On January 28, 1998, the Company granted additional options to acquire up to
150,000 shares of common stock under the 1995 Stock Option Plan for Officers and
Key Management Employees as discussed in note 9. The market price on the date of
grant was $0.50 per share which is less than the average market price in 1997 or
1995 and, therefore, would have been dilutive if outstanding in such periods. In
addition, subsequent to year end, options to acquire 100,000 shares under the
same plan were forfeited.

9. STOCKHOLDERS' EQUITY

Stock Option Plans

The Company has outstanding options to purchase its common stock under The 1995
Stock Option Plan for officers and key management employees and The 1995
Director Non-qualified Stock Option Plan for non-employee directors. The plan
for employees provides for the granting of either qualified incentive stock
options or non-qualified options at the discretion of the Compensation Committee
of the Board of Directors. Options are granted at the fair market value of the
underlying common stock at the date of grant. Employee options vest over a
five-year period while the director options vest after six months. All options
expire ten years from the date of grant and are exerciseable at any time after
vesting. The Company has reserved 1,100,000 shares of common stock for issuance
under these plans, and at December 31, 1997, 1996 and 1995, there were 534,000;
590,000; and 515,000; respectively, in un-optioned shares available for future
grants.

A summary of the Company's stock option activity and related information for the
years ended December 31, 1997, 1996 and 1995, is as follows:

1997 1996 1995
----------------------- ---------------------- ----------------------
Weighted Weighted Weighted
Average Average Average
Option Exercise Option Exercise Option Exercise
Shares Price Shares Price Shares Price
------------ ---------- ----------- ----------- ---------- ----------
Outstanding at January 1 510,000 $ 2.653 585,000 $ 3.063 - $ -
Granted * 456,000 0.805 106,000 1.088 585,000 3.063
Forfeited - - (181,000) 3.063 - -
Exchanged * (400,000) 3.063 - - - -
Exercised - - - - - -
------------ ----------- ----------- ----------- ---------- ----------
Outstanding at December 31 566,000 $ 0.874 510,000 $ 2.653 585,000 $ 3.063
=========== =========== =========== ========== ========== ==========
Exercisable at end of year 190,000 $ 0.908 84,000 $ 3.063 - $ -
============ =========== =========== =========== ========== ==========
Weighted-average fair value of
options granted during year $ 0.31 $ 0.52 $ 1.45
============ =========== ==========

* In 1997, options originally granted in 1995 were canceled and reissued. This
action was taken to provide incentive to and in order to retain the Company's
key management personnel in light of the severe decline in the market price for
the Company's common stock.

The following table segregates outstanding options into groups based upon
exercise price ranges.

Outstanding Exercisable
------------------------------------ ---------------------------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
Option Exercise Maturity Option Exercise Maturity
Exercise Price Range Shares Price (Years) Shares Price (Years)
--------------------
------------ ---------- ----------- ------------ ---------- ----------
$0.75 or Less 31,000 $ 0.700 9.75 - $ - -
More than $0.75 &
Less Than $1.00 425,000 0.813 7.84 160,000 0.813 7.75
More than $1.00 110,000 1.159 8.79 30,000 1.417 8.67
------------ ---------- ----------- ------------ ---------- ----------
566,000 $ 0.874 8.13 190,000 $ 0.908 7.90
============ ========== =========== ============ ========== ==========

28

Pro forma information regarding net income (loss) and earnings (loss) per share
is required by SFAS 123, and has been determined as if the Company had accounted
for its stock options under the fair value method. The fair value for these
options was estimated at the date of grant using the Black Scholes option
pricing model with the following weighted-average assumptions: risk-free
interest rates of 6.64% in 1997; 6.72% in 1996 and 6.38% in 1995; dividend
yields of 0% for all years; volatility factors of .550 for 1997 and .439 for
both 1996 and 1995; and an expected life of the valued options of 5 years for
all years other than the exchanged options reissued in 1997 which have an
expected remaining life of 4 years.

Option valuation models require the input of highly subjective assumptions,
including the expected stock price volatility, and changes in these input
assumptions can materially affect the fair value estimate they produce. Because
of this, it is management's opinion that existing models do not necessarily
provide a reliable single measure of fair value for the Company's stock options.
For pro forma disclosures, the estimated fair values determined by the model are
being amortized to expense on a straight-line basis over the options vesting
period as adjusted for estimated forfeitures. The Company's pro forma
information follows:

1997 1996 1995
------------ ------------ ------------
Pro forma net income (loss) $ (76,117) $(1,057,818) $1,121,736

Pro forma earnings (loss) per common share $ (.01) $ (0.11) $ 0.11

Pro forma earnings (loss) per common share-
Assuming Dilution $ (.01) $ (0.11) $ 0.11

Warrants

In connection with the issuance of the Subordinated Debenture discussed in note
3 above, the Company issued warrants to acquire up to 100,000 shares of Common
Stock at approximately $.54 per share to an unrelated individual. The warrants
may be exercised at anytime until expiration on November 21, 2002. The fair
value for these warrants was estimated at the date of grant using the Black
Scholes option pricing model with the following weighted-average assumptions:
risk-free interest rate of 6.5%; dividend yield of 0%; volatility factor of
.550; and an expected life of 3 years.

Notes Receivable Secured by Common Stock

During 1996, the Company purchased certain notes from NationsBank that are
collateralized by the Company's common stock. These notes relate to shares
issued under the Company's 1993 Non-Qualified Incentive Stock Option Plan. These
notes, as renewed in 1997, are due from seven individuals including officers and
other members of management, require monthly payments, and mature on December
31, 2000.

10. ACQUISITIONS

On January 2, 1995, the Company acquired all of the issued and outstanding
shares of capital stock of Roberts, Cushman & Co., Inc. ("Cushman"), a
manufacturer of fancy hat trims located in New York, New York, for an
approximate purchase price of $5,000,000. The purchase price was funded with the
proceeds of the NationsBank Term Loan discussed in Note 3 above, which along
with legal and other acquisition costs, comprised the restricted assets at
December 31, 1994. The purchase was accounted for under the purchase method,
effective January 1, 1995.

On January 31, 1995, the Company acquired certain assets of Gulf Coast Leather
Company, Inc., a distributor of shoe care and repair supplies located in New
Orleans, Louisiana. The assets purchased included inventory, furniture,
fixtures, equipment, and rental and utility deposits. The total purchase price
was approximately $91,869 which was funded with cash generated from operations.
The purchase was accounted for under the purchase method, effective January 31,
1995.

On December 29, 1995, the Company acquired certain assets of B & J Leather
Company ("B & J") of Fort Worth, Texas, which was engaged primarily in the sale
of leather and related products to the shoe repair and care industry. These
assets, which included primarily salable inventory and intangible assets such as
vendor and customer lists, were valued at $100,094 which was funded with cash
generated from operations. The two principal shareholders of B & J were employed
by the Company subsequent to closing, with the business performed by B & J being
incorporated into the Company's sales/distribution unit located in Fort Worth,
Texas. The purchase was accounted for under the purchase method, effective
December 31, 1995.

29

On March 1, 1996, the Company acquired all of the issued and outstanding shares
of capital stock of The Leather Factory of Canada, Ltd., the Company's Canadian
distributor located in Winnipeg, Manitoba. The total purchase price was
approximately $300,000 which was funded with cash generated from operations and
the Company's revolving credit facility. The purchase was accounted for under
the purchase method, effective March 1, 1996.

11. FAIR VALUE OF FINANCIAL INSTRUMENTS

Cash and accounts receivable-trade
The carrying amount approximates fair value because of the short maturity of
those instruments.

Accounts payable
The carrying amount approximates fair value because of the short maturity of
those instruments.

Notes payable and long-term debt
With the exception of the Subordinated Debenture, the interest rates on the
Company's notes payable and long-term debt fluctuate with changes in the prime
rate and are the rates currently available to the Company; therefore, the
carrying amount of those instruments approximates their fair value.

The terms of the Subordinated Debenture are the terms management believes would
be currently available to the Company for this type of financing; therefore, the
carrying amount approximates fair value.

30

12. QUARTERLY FINANCIAL DATA (UNAUDITED)

First Second Third Fourth
1997 Quarter Quarter Quarter Quarter
- ------------------------------------ ----------------------------------------------------------------------
Net sales $ 6,459,892 $ 6,526,992 $ 6,353,582 $ 6,058,650
Gross profit 2,563,811 2,739,284 2,693,991 2,557,654
Net income (loss) (36,185) 87,858 92,439 (73,820)

Earnings (loss) per common share - 0.01 0.01 (0.01)
Earnings (loss) per common
share--assuming dilution - 0.01 0.01 (0.01)

Weighted average number of
common shares outstanding:
Basic 9,788,530 9,788,530 9,788,530 9,791,841
Diluted 9,788,530 9,788,530 9,788,630 9,800,569

**First (*)(**) Second **Third Fourth
1996 Quarter Quarter Quarter Quarter
- ------------------------------------ ----------------------------------------------------------------------
Net sales $ 7,356,805 $ 7,155,218 $ 7,015,834 $ 6,725,775
Gross profit 2,894,664 2,337,962 2,777,628 2,553,405
Net income (loss) (21,994) (810,963) 14,391 (171,202)

Earnings (loss) per common share - (0.08) - (0.02)
Earnings (loss) per common
share--assuming dilution - (0.08) - (0.02)

Weighted average number of
common shares outstanding:
Basic 9,788,530 9,788,530 9,788,530 9,788,530
Diluted 9,788,530 9,788,530 9,788,530 9,788,530

* The second quarter results for 1996 include several items that affect the
comparability to the other quarters. These items include the write-off of
deferred costs related to financing commitments that expired, the goodwill
write-down, the write-off of a large bad debt due to a customer bankruptcy, and
a minimum royalty accrual and inventory write-off due to a licensing agreement.
The aggregate amount of these costs were approximately $560,000.

** The results for the first through the third quarters of 1996 were affected by
excessive labor, production, travel and legal cost related to the labor dispute
at the Company's New York facility that affect comparability to the other
quarters. The labor dispute was settled on favorable terms in October of 1996.
The aggregate amount of these costs were approximately $475,000.

31

THE LEATHER FACTORY, INC.
SCHEDULE II --VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
Years Ended December 31, 1997 and 1996

ALLOWANCE FOR DOUBTFUL ACCOUNTS
1997 1996
--------- ---------
Balance at beginning of year $ 54,000 $ 39,000

Additions (reductions) charged to income (4,000) 229,000

Balances written off, net of recoveries (22,000) (214,000)
--------- --------

Balance at end of year $ 28,000 $ 54,000
========= ========

32

REPORT OF INDEPENDENT AUDITORS

The Board of Directors
The Leather Factory, Inc.

We have audited the accompanying consolidated balance sheets of The Leather
Factory, Inc. as of December 31, 1997 and 1996, and the related consolidated
statements of income, stockholders' equity, and cash flows for the years then
ended. Our audit also included the financial statement schedule referred to in
the index at Item 14(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 generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits 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 The Leather
Factory, Inc. at December 31, 1997 and 1996, and the consolidated results of its
operations and its cash flows for the years then ended, in conformity with
generally accepted accounting principles. 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

Fort Worth, Texas
March 4, 1998

33

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

TO THE STOCKHOLDERS OF
THE LEATHER FACTORY, INC.:

We have audited the accompanying consolidated statements of income,
stockholders' equity, and cash flow of The Leather Factory, Inc. (a Delaware
corporation) and subsidiaries for the year ended December 31, 1995. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, The Leather Factory, Inc. and subsidiaries results of
operations and their cash flows for the year ended December 31, 1995, in
conformity with generally accepted accounting principles.

/s/ ARTHUR ANDERSEN LLP

Fort Worth, Texas
February 16, 1996

34

PART III

Item 10. Directors and Executive Officers of the Registrant.

Information required by this item is incorporated by reference to the
material appearing under the heading "Election of Directors" and "Executive
Officers of the Company" in the Proxy Statement for the 1998 Annual Meeting of
Stockholders.

Item 11. Executive Compensation.

Information required by this item is incorporated by reference to the
material appearing under the heading "Executive Compensation" in the Proxy
Statement for the 1998 Annual Meeting of Stockholders.

Item 12. Security Ownership of Certain Beneficial Owners and Management.

Information required by this item is incorporated by reference to the
material appearing under the heading "Security Ownership of Certain Beneficial
Owners and Management" and "Certain Transactions" in the Proxy Statement for the
1998 Annual Meeting of Stockholders.

Item 13. Certain Relationships and Related Transactions.

Information required by this item is incorporated by reference to the
material appearing under the heading "Certain Transactions" in the Proxy
Statement for the 1998 Annual Meeting of Stockholders.

PART IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.

(a) 1. Financial statements and financial statement schedules

The financial statements and schedule listed in the accompanying index to
the consolidated financial statements at Item 8 are filed as part of this
Report.

2. Exhibits:

The exhibits listed on the accompanying Exhibit Index, which immediately
precedes such exhibits, are filed or incorporated by reference as part of this
Report and such Exhibit Index.

(b) Reports on Form 8-K

None.

35

SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of
1934, the Company caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.

THE LEATHER FACTORY, INC.
(Registrant)

Date: March 27, 1998 /s/ Wray Thompson
--------------------------------
Wray Thompson
Chairman of the Board, President,
and Chief Executive Officer

In accordance with the Securities Exchange Act of 1934, this Report has
been signed below by the following persons on behalf of the Company and in the
capacities and on the dates indicated.

Signature Title Date
--------- ----- ----

/s/ Anthony C. Morton Chief Financial Officer, March 27, 1998
- --------------------- Treasurer and Director
Anthony C. Morton (Chief Accounting Officer)

/s/ Wray Thompson Chairman of the Board March 27, 1998
- ---------------------
Wray Thompson

/s/ Ronald C. Morgan Director March 27, 1998
- ---------------------
Ronald C. Morgan

/s/ Robin L. Morgan Director March 27, 1998
- ---------------------
Robin L. Morgan

/s/ William M. Warren Director March 27, 1998
- ---------------------
William M. Warren

/s/ H. W. Markwardt Director March 27, 1998
- ---------------------
H. W. Markwardt

36

THE LEATHER FACTORY, INC. AND SUBSIDIARIES
EXHIBIT INDEX

Exhibit Description
Number -----------
-------
3.1 Certificate of Incorporation of The Leather Factory, Inc.,
filed as Exhibit 3.1 to the Registration Statement on Form
SB-2 of The Leather Factory, Inc. (Commission File No.
33-81132) filed with the Securities and Exchange Commission on
July 5, 1994, and incorporated by reference herein.

3.2 Bylaws of The Leather Factory, Inc., filed as Exhibit 3.2 to
the Registration Statement on Form SB-2 of The Leather
Factory, Inc. (Commission File No. 33-81132) filed with the
Securities and Exchange Commission on July 5, 1994, and
incorporated by reference herein.

4.1 Sixth Amendment to Second Restated Loan Agreement effective as
of April 30, 1997, by and between The Leather Factory, Inc., a
Delaware Corporation, and NationsBank of Texas, N.A., filed as
Exhibit 4.14 to the Quarterly Report on Form 10-Q of The
Leather Factory, Inc. (Commission File No. 1-12368) filed with
the Securities and Exchange Commission on May 15, 1997, and
incorporated by reference herein.

4.2 Forbearance Agreement effective as of August 31, 1997, by and
between The Leather Factory, Inc., a Delaware Corporation, and
NationsBank of Texas, N.A., filed as Exhibit 4.15 to the
Quarterly Report on Form 10-Q of The Leather Factory, Inc.
(Commission File No. 1-12368) filed with the Securities and
Exchange Commission on November 14, 1997, and incorporated by
reference herein.

4.3 Loan and Security Agreement dated November 21, 1997, by and
between The Leather Factory, Inc., a Delaware corporation, The
Leather Factory, Inc., a Texas corporation, The Leather
Factory, Inc., an Arizona corporation, Hi-Line Leather &
Manufacturing Company, a California corporation, Roberts,
Cushman & Company, Inc., a New York corporation, and FINOVA
Capital Corporation, filed as Exhibit 4.1 to the Current
Report on Form 8-K of The Leather Factory, Inc. (Commission
File No. 1-12368) filed with the Securities and Exchange
Commission on February 6, 1998, and incorporated by reference
herein.

4.4 Revolving Note (Revolving Credit Loan) dated November 21,
1997, in the principal amount of $7,000,000, payable to the
order of FINOVA Capital Corporation, which matures December 1,
1999 filed as Exhibit 4.2 to the Current Report on Form 8-K of
The Leather Factory, Inc. (Commission File No. 1-12368) filed
with the Securities and Exchange Commission on February 6,
1998, and incorporated by reference herein.

4.5 Term Loan A Note (Term Loan A) dated November 21, 1997, in the
principal amount of $400,000, payable to the order of FINOVA
Capital Corporation, which matures December 1, 1999 filed as
Exhibit 4.3 to the Current Report on Form 8-K of The Leather
Factory, Inc. (Commission File No. 1-12368) filed with the
Securities and Exchange Commission on February 6, 1998, and
incorporated by reference herein.

4.6 Term Loan B Note (Term Loan B) dated November 21, 1997, in the
principal amount of $236,000, payable to the order of FINOVA
Capital Corporation, which matures December 1, 1999 filed as
Exhibit 4.4 to the Current Report on Form 8-K of The Leather
Factory, Inc. (Commission File No. 1-12368) filed with the
Securities and Exchange Commission on February 6, 1998, and
incorporated by reference herein.

4.7 Term Loan C Note (Term Loan C) dated November 21, 1997, in the
principal amount of $1,500,000, payable to the order of FINOVA
Capital Corporation, which matures December 1, 1999 filed as
Exhibit 4.5 to the Current Report on Form 8-K of The Leather
Factory, Inc. (Commission File No. 1-12368) filed with the
Securities and Exchange Commission on February 6, 1998, and
incorporated by reference herein.

4.8 Subordination Agreement dated November 21, 1997, by and
between FINOVA Capital Corporation, The Schlinger Foundation,
The Leather Factory, Inc., a Delaware corporation, The Leather
Factory, Inc., a Texas corporation, The Leather Factory, Inc.,
an Arizona corporation, Hi-Line Leather & Manufacturing
Company, a California corporation, and Roberts, Cushman &
Company, Inc., a New York corporation filed as Exhibit 4.6 to
the Current Report on Form 8-K of The Leather Factory, Inc.
(Commission File No. 1-12368) filed with the Securities and
Exchange Commission on February 6, 1998, and incorporated by
reference herein.

37

THE LEATHER FACTORY, INC. AND SUBSIDIARIES
EXHIBIT INDEX
(CONTINUED)

Exhibit Description
Number -----------
-------
4.9 Pledge Agreement dated November 21, 1997, by and between
Ronald C. Morgan and Robin L. Morgan and FINOVA Capital
Corporation filed as Exhibit 4.7 to the Current Report on Form
8-K of The Leather Factory, Inc. (Commission File No. 1-12368)
filed with the Securities and Exchange Commission on February
6, 1998, and incorporated by reference herein.

4.10 Patent Security Agreement dated November 21, 1997, by and
between The Leather Factory, Inc., a Delaware corporation, The
Leather Factory, Inc., a Texas corporation, The Leather
Factory, Inc., an Arizona corporation, Hi-Line Leather &
Manufacturing Company, a California corporation, Roberts,
Cushman & Company, Inc., a New York corporation, and FINOVA
Capital Corporation filed as Exhibit 4.8 to the Current Report
on Form 8-K of The Leather Factory, Inc. (Commission File No.
1-12368) filed with the Securities and Exchange Commission on
February 6, 1998, and incorporated by reference herein.

4.11 Trademark Security Agreement dated November 21, 1997, by and
between The Leather Factory, Inc., a Delaware corporation, The
Leather Factory, Inc., a Texas corporation, The Leather
Factory, Inc., an Arizona corporation, Hi-Line Leather &
Manufacturing Company, a California corporation, Roberts,
Cushman & Company, Inc., a New York corporation, and FINOVA
Capital Corporation filed as Exhibit 4.9 to the Current Report
on Form 8-K of The Leather Factory, Inc. (Commission File No.
1-12368) filed with the Securities and Exchange Commission on
February 6, 1998, and incorporated by reference herein.

4.12 Copyright Security Agreement dated November 21, 1997, by and
between The Leather Factory, Inc., a Delaware corporation, The
Leather Factory, Inc., a Texas corporation, The Leather
Factory, Inc., an Arizona corporation, Hi-Line Leather &
Manufacturing Company, a California corporation, Roberts,
Cushman & Company, Inc., a New York corporation, and FINOVA
Capital Corporation filed as Exhibit 4.10 to the Current
Report on Form 8-K of The Leather Factory, Inc. (Commission
File No. 1-12368) filed with the Securities and Exchange
Commission on February 6, 1998, and incorporated by reference
herein.

4.13 Promissory Note (Subordinated Debenture) dated November 14,
1997, in the principal amount of $1,000,000, payable to the
order of The Schlinger Foundation, which matures December 1,
1999 filed as Exhibit 4.11 to the Current Report on Form 8-K
of The Leather Factory, Inc. (Commission File No. 1-12368)
filed with the Securities and Exchange Commission on February
6, 1998, and incorporated by reference herein.

4.14 Pledge and Security Agreement dated November 14, 1997, by and
between The Schlinger Foundation and J. Wray Thompson, Sr.
filed as Exhibit 4.12 to the Current Report on Form 8-K of The
Leather Factory, Inc. (Commission File No. 1-12368) filed with
the Securities and Exchange Commission on February 6, 1998,
and incorporated by reference herein.

21.1 Subsidiaries of the Company, filed as Exhibit No. 22.1 to the
1995 Annual Report on Form 10-KSB of The Leather Factory, Inc.
(Commission File No. 1-12368), filed with the Securities and
Exchange Commission on March 28, 1996, and incorporated herein
by reference.

*23.1 Consent of Ernst & Young LLP dated March 24, 1998.

*23.2 Consent of Arthur Andersen LLP dated March 24, 1998.

*27.1 Financial Data Schedule
------------
*Filed herewith.

38

EXHIBIT 23.1

39

CONSENT OF INDEPENDENT AUDITORS

We consent to the incorporation by reference in the Registration Statement (Form
S-8 No. 33-81214) pertaining to the Employee Stock Ownership Plan and Trust of
The Leather Factory, Inc. and the Registration Statement (Form S-8 No.
333-07147) pertaining to the 1995 Stock Option Plan of The Leather Factory, Inc.
of our report dated March 4, 1998, with respect to the consolidated financial
statements and schedule of The Leather Factory, Inc. included in the Annual
Report (Form 10-K) for the year ended December 31, 1997.

/s/ ERNST & YOUNG LLP

Fort Worth, Texas
March 24, 1998

40

EXHIBIT 23.2

41

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-K, into the Company's previously filed Form S-8
Registration Statements on File Nos. 33-81214 and 333-07147.

/s/ ARTHUR ANDERSEN LLP

Fort Worth, Texas
March 24, 1998

42

EXHIBIT 27.1

43