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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended July 31, 2003

Commission File No.: 0-24338

VARIFLEX, INC.

(Exact name of Registrant as specified in its charter)

5152 North Commerce Avenue

Moorpark, California 93021

(Address of principal executive offices)

Registrant’s telephone number, including area code:

(805) 523-0322

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

None

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

Common Stock, $.001 par value per share

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 ¨

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

The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of January 31, 2003 was approximately $5,073,000 based upon the closing sale price of the Registrant’s Common Stock on such date, as reported on the Nasdaq SmallCap Market. Shares of Common Stock held by each executive officer and director and each person owning more than 5% of the outstanding Common Stock of the Registrant have been excluded in that such persons may be deemed to be affiliates of the Registrant. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

Shares of $.001 par value Common Stock outstanding at October 1, 2003: 4,603,771 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement for its 2003 Annual Meeting of Stockholders scheduled to be held on December 12, 2003 are incorporated by reference into Part III of this Form 10-K.

Forward-Looking Statements

All statements, other than statements of historical fact, contained within this report constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases you can identify forward-looking statements by terms such as “may,” “intend,” “might,” “will,” “should,” “could,” “would,” “expect,” “believe,” “estimate,” “potential,” “expect,” “plan” or the negative of these terms, and similar expressions intended to identify forward-looking statements.

These forward-looking statements reflect our current views with respect to future events and are based on assumptions and are subject to risks and uncertainties. Also, these forward-looking statements present our estimates and assumptions only as of the date of this report. Except as required by federal securities laws, we do not intend to update you concerning any future revisions to any forward-looking statements to reflect events or circumstances occurring after the date of this report.

Factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements include, but are not limited to, those described in “Risk Factors” or in the documents incorporated by reference in this report.

PART I

The Company was originally incorporated in California in 1977, and reincorporated in Delaware in March 1994. The Company is a distributor and wholesaler of in-line skates, skateboards, scooters, recreational protective equipment (such as wrist guards, elbow pads and knee pads used by skaters and skateboarders) and helmets, canopies, and springless trampolines. The Company designs and develops these products which are then manufactured to the Company’s detailed specifications by independent contractors. The Company distributes its products throughout the United States and to a lesser extent in foreign countries.

The following table shows the Company’s major product categories as a percentage of total gross sales for the fiscal years ended July 31, 2003, 2002, and 2001 (see footnote 1, segment information, in notes to financial statements). Action sport products include in-line skates, skateboards, scooters, bodyboards and bike accessories. The outdoor products include canopies and springless trampolines. Protective products include recreational protective equipment, such as wrist guards, elbow pads, knee pads and helmets. Other products consist primarily of replacement parts.

The Company has developed and markets its Quik Shade^® instant canopy that is designed to offer portable shade and shelter for a variety of uses with the convenience of quick set-up and take-down. Canopies generally are sold in a variety of sizes and colors. They contain a fully assembled powder coated frame with multiple height adjustments, aluminum backed polyester tops offering 100% protection from harmful UV rays, storage bags and anchoring kits. The Company presently offers multiple models of the Quik Shade^® and a line of Quik Shade^® accessories.

The Company has developed and markets, under an exclusive license agreement, a springless trampoline that makes use of elastic bands for its suspension system. The agreement gives the Company worldwide rights to the patented technology for the duration of the patent. The trampolines come in different sizes and are sold under the Airzone^™ and Ultraflex^™ brands. Additionally, the Company markets mini-trampolines, trampoline enclosures and trampoline covers.

In-line skates feature wheels mounted in a straight line on a composite plastic or aluminum chassis, functioning much like the blade on an ice skate. The Company sells various models of in-line skates to the mass market under the VFX^® brand. The Company’s in-line skates generally consist of a molded polymer boot with a wheel chassis attached to the bottom of the boot, and high density polyurethane wheels mounted on bearings and bolted through the wheel chassis. The boot contains a removable breathable nylon liner that increases comfort. Each chassis holds three or four wheels mounted in line, and each pair of skates has either one or two brakes mounted on the rear of the chassis.

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The Company markets a wide range of skateboards and scooters. The Company presently offers different models of skateboards and scooters under the Variflex^®, VFX^®, Static^® and other licensed brands.

The Company also markets a line of recreational protective helmets. Different helmets are marketed to cyclists, snowboarders, skateboarders and in-line skaters. The Company’s helmets are manufactured by independent contractors using either a process of injecting a polyurethane foam or expanded polystyrene (EPS) to form a strong, lightweight protective inner shell bonded to a hard PVC outer shell. These helmets meet or exceed the applicable standards of the American Society for Testing and Materials (ASTM) or the Consumer Product Safety Commission (CPSC). We also offer a line of skating and skateboarding protective equipment, such as knee pads, elbow pads and wrist guards.

Additionally, the Company offers bodyboards and a line of bicycle accessories, such as lights, pumps, locks, saddles and tubes under the brand name “Cycle-Force^™”.

The Company’s products are marketed in North America primarily through a network of independent sales representatives and through customer visits by Company employees. The Company’s customers consist primarily of national mass merchandisers, regional mass merchandisers, catalog houses, major sporting goods chains and major home improvement chains.

Source and availability of materials.

The Company’s products are sourced from independent contractors located primarily in Asia. These suppliers manufacture, assemble and package the Company’s products under the detailed specifications of the Company’s management representatives who visit frequently to oversee quality control and contain costs The raw materials and subcomponents for these products are manufactured by independent contractors, most of which are also located in Asia, that have been procured by the Company’s suppliers or, often, by the Company.

The Company submits purchase orders to its manufacturers for the production of specific amounts of its products and has not entered into any long-term contractual agreements. The Company negotiates the cost of its products directly with its foreign suppliers in U.S. Dollars.

A significant portion of the Company’s products are manufactured in mainland China, which trades with the United States under a Normal Trade Relations (“NTR”) trade status. While the Company believes that alternative manufacturing sources could be found, maintaining existing costs will depend upon these products continuing to be treated under NTR tariff rates. From time to time, the U.S. has threatened to rescind NTR tariff rates and impose trade sanctions on certain goods manufactured in China. To date, no such sanctions have been imposed that have affected the Company or its products; however there can be no assurance with regard to the possible imposition of sanctions in the future.

Patents, trademarks, licenses, franchises and concessions.

The Company holds or has pending certain design patents and utility patents. In the course of its business the Company employs various trademarks and trade names, including its own logos, in the packaging and advertising of its products. The Company has registered the Variflex^®, VFX^®, Static^®, Quik Shade^®, Motoshade^™, Motoshed^™, Ultraflex^™, Airzone^™ and CycleForce^™ trademarks in the United States, and actively protects against any unauthorized use. Registrations of various other trademarks for the Company’s products are pending.

During fiscal 2003, the Company entered into a license agreement with “NASCAR^®” to produce the “NASCAR^®” logo on instant canopies. The Company also entered into a license agreement with “NO-RULES^®”, to produce several lines of in-line skates, helmets, skateboards, scooters, protective pads, accessories and other new products to be introduced in the future. Both these licenses expire in December 2004. These new licenses complement the Company’s other licenses currently in use; “SpongeBob Squarepants^®”, “Rocket Power^®” and “Jimmy Neutron^®”, all three of which are popular animation programs on the Nickelodeon channel. The “Rocket Power^®” and “SpongeBob Squarepants^®” agreements expire in December 2003, while the “Jimmy Neutron^®” agreement expires in December 2004. The Company is currently in negotiations and believes that it will renew the “SpongeBob^®” and “Rocket Power^®” licenses for another two-year period.

During fiscal 1999, the Company entered into an exclusive license agreement with Product Resource and Development, Inc. to manufacture and market a springless trampoline that uses an elastic material to provide the bounce and lift. The agreement gives the Company worldwide rights to the patented technology for the duration of the patent. The trampolines are being sold under the Airzone^™ and Ultraflex^™ brands. Additionally, the Company markets mini trampolines, trampoline enclosures and trampoline covers.

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Major customers.

The Company had four customers (The Sports Authority, Target, Toys “R” Us and Wal-Mart) that individually accounted for in excess of 10% of the Company’s sales in 2003. These companies represented, in aggregate, approximately 59% of the Company’s total sales in 2003. The loss of any one or more of the Company’s major customers could have a material adverse effect upon the Company.

Backlog.

Backlog may not be indicative of future sales as timeliness of order placement and shipments vary. In addition, order cancellation or other adjustments may occur. The Company had approximately $5,250,000 in unfilled purchase orders as of September 30, 2003, compared to approximately $7,360,000 as of September 30, 2002. The decrease in backlog is due primarily to a decrease in unfilled orders of in-line skates, skateboards and scooters.

Competition.

The principal competitive factors in each of the Company’s product categories are price, quality, brand recognition and customer service, with the most important factors being price and quality. The Company believes that its products in each category, when compared to competitors’ products of comparable quality, are currently offered at similar prices to most of its competitors.

Independent research indicates that the Company has a significant market share in the in-line skate category, particularly in the mass market segment, where Variflex enjoys name recognition and is considered a market leader. The Company’s primary competitors in the in-line skate market include Rollerblade Inc., Roller Derby (CAS) and World Sports. In the case of recreational protective equipment, CXSports is the Company’s primary competitor in the mass market. Bell Sports Corp. (Bell) and Protective Technologies, Inc. (PTI) are the primary competitors in the recreational helmet mass market. For instant canopies, the Company’s primary competitors are International E-Z Up, Inc., Powell & Powell and Caravan. For trampolines, the Company’s primary competitors are Jumpking, Inc. and Hedstrom.

Employees.

As of July 31, 2003, the Company employed approximately 91 full-time employees. None of the Company’s employees are represented by unions.

The Company’s principal facility is a leased 104,000 square foot concrete tilt-up building comprising the Company’s corporate headquarters and executive offices, as well as serving as the United States distribution center for the Company’s products, located at 5152 North Commerce Avenue, Moorpark, California, approximately forty miles northwest of Los Angeles, California. The Company also leases an immediately adjacent 31,233 square foot building, consisting primarily of additional warehouse space. The leases for these facilities expire December 31, 2005 with a five-year renewal option, after which management believes new leases can be negotiated, at those locations or for other equivalent space, on commercially satisfactory terms. The Company also leases two additional buildings used for warehouse space (in aggregate approximately 55,000 square feet) under operating leases requiring minimum monthly payments of approximately $25,000 and $3,600, respectively, both of which amounts include property taxes, insurance, repairs and maintenance, and utilities. These agreements both expire in June 2004.

Management believes that the Company’s present facilities will be adequate for the near future.

On December 19, 2001, JumpSport Inc., filed a complaint in the United States District Court for the Northern District of California against the Company and ten other entities (the “JumpSport Action”). The complaint alleged, among other things, that the Company’s trampoline enclosures infringed and continues to infringe two patents owned by the plaintiff.

The Company has settled the litigation with JumpSport, Inc. In accordance with the terms of the settlement agreement, JumpSport, Inc has dismissed all claims. The terms of the settlement are subject to a confidentiality agreement.

From time to time, the Company is involved in claims involving product liability arising in the ordinary course of its business. The Company carries product liability insurance coverage with self insured retention deductible claims. A prior year insurance carrier has declared bankruptcy and as such, coverage for one claim has the potential of not being covered by insurance. At July 31, 2003 the Company has a reserve against all insured and uninsured claims. In the opinion of management, any additional liability to the Company arising under any pending product liability claims would not materially affect its financial position, results of operations or cash flows.

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No matters were submitted to a vote of the Company’s stockholders during the quarter ended July 31, 2003.

PART II

(a) Market Information.

The high and low last sale prices for the Company’s common stock, as reported on the Nasdaq National Market, during each of the quarters of the fiscal years ended July 31, 2002 and 2003 were as follows (per share):

The Company’s Common Stock is traded on the Nasdaq SmallCap Market under the symbol “VFLX.” As of October 1, 2003, the closing sale price of the Company’s Common Stock on the Nasdaq SmallCap Market was $6.39.

(b) Holders.

There were 99 holders of record of the Company’s Common Stock on October 1, 2003.

(c) Dividends.

The Company has never paid cash dividends and has no present intention to pay cash dividends in the foreseeable future. The Delaware General Corporation Law also restricts the Company’s ability to pay dividends. The Delaware General Corporation Law provides that a Delaware corporation may pay dividends either (1) out of the corporation’s surplus (as defined by Delaware law), or (2) if there is no surplus, out of the corporation’s net profit for the fiscal year in which the dividend is declared or the preceding fiscal year. Any determination in the future to pay dividends will depend on the Company’s financial condition, capital requirements, results of operations, contractual limitations, legal restrictions and any other factors the Board of Directors deems relevant.

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The following selected consolidated financial data with respect to the Company’s consolidated financial position as of July 31, 2003 and 2002 and results of operations for the years ended July 31, 2003, 2002, and 2001 has been derived from the Company’s audited consolidated financial statements appearing elsewhere in this report. This information should be read in conjunction with such consolidated financial statements and the notes thereto. The selected financial data with respect to the Company’s consolidated financial position as of July 31, 2001, 2000 and 1999 and results of operations for the years ended July 31, 2000 and 1999 has been derived from the Company’s audited consolidated financial statements, which are not presented in this report.

Overview

Net sales consist of invoiced sales less agreed upon rebates and discounts (primarily returns and allowances, and cooperative advertising expenses). The Company sells its products primarily through mass merchandise, major sporting goods and major home improvement channels. The Company uses independent sales representatives to provide sales support.

Cost of goods sold consists of product costs, freight distribution (as well as warehouse costs), payroll expenses, facility costs, and other product related costs such as warranty expenses and royalty fees. The Company does not own or operate any manufacturing facilities and sources its products through independent contract manufacturers.

Operating expenses consist of selling and marketing costs and general and administrative costs. Selling and marketing costs consist of payroll expenses, sales commissions and other promotional items. General and administrative costs consist of payroll, legal, accounting, information systems, product development, intangible amortization and other overhead expenses.

Other income and expenses consists of interest income, interest expense and other non-operating items.

New Accounting Standards

In August 2002, the Financial Accounting Standards Board (“FASB”) issued Statement on Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”, which requires that costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. These new standards will be prospectively applied for exit or disposal activities initiated after December 31, 2002. If exit or disposal activities are initiated after that date, SFAS No. 146 will affect the timing of the recognition of the related costs. The Company does not expect the adoption of this standard to have a significant impact on its financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transaction and Disclosure-an amendment of FASB Statement No. 123”. SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based

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Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has included disclosures in its quarterly reports and this annual report.

Results of Operations

Year Ended July 31, 2003 Compared to Year Ended July 31, 2002

Net Sales. Net sales for the fiscal year ended July 31, 2003 totaled $57,884,000, an increase of $11,438,000 or 25% from fiscal 2002 net sales of $46,446,000. The increase in net sales for the year is attributable to an increase in sales of action sport products and outdoor products partially offset by a decrease in sales of protective products.

Gross sales of the action sport product category (which includes in-line skates, skateboards, scooters, bodyboards and bike accessories) increased $8,578,000 or 52% to $ 25,221,000 in 2003 from $16,643,000 in 2002. The increase in action sports was primarily the result of greater sales of in-line skates because the Company secured an exclusive in-line skate program with one of its top customers for a two-year period beginning in 2003 and, to a lesser extent, increased sales of other products.

Gross sales of outdoor products (which include canopies and springless trampolines) increased $5,293,000, or 19% to $33,449,000 in 2003 from $28,156,000 in 2002. The increase in outdoor products was a result of a 29% increase in sales of canopies partially offset by a 7% decline in sales of trampolines.

The overall increase in gross sales in both action sports and outdoor products were partially offset by a $2,046,000, or 50% reduction in protective products (which include recreational protective equipment such as wrist guards, elbow pads, knee pads and helmets) as gross sales of this category were $2,080,000 in 2003 and $4,126,000 in 2002. This decrease in gross sales of protective products was largely the result of the expiration of a license to use the X-Games logo on certain products.

Four customers in fiscal 2003 individually accounted for more than 10% of the Company’s gross sales. Collectively these four customers accounted for approximately 59% of the Company sales in 2003, compared to the prior year where three customers exceeded 10% of sales and in aggregate, accounted for 40% of the Company’s gross sales.

Gross Profit. Gross profit for the fiscal year ended July 31, 2003 increased $2,086,000 compared to fiscal year ended July 31, 2002, representing a 28.5% increase. The Company’s gross margin increased to 16.3% in fiscal 2003 compared to 15.8% in fiscal 2002. The increase in gross margin for the year was due to the 25% increase in sales during the period and by a substantial portion of labor and overhead costs being fixed in nature and, therefore, not increasing with higher sales volumes. Partially offsetting this increase in gross margin were lower gross margins on an increase in products shipped directly to customers from Asia which have lower gross margins, and overall competitive pricing on certain products resulting in lower prices.

Operating Expenses. The Company’s operating expenses (which consist of selling and marketing expenses and general and administrative expenses) for fiscal 2003 totaled $8,086,000, or 14.0% of net sales. Operating expenses for fiscal 2002 were $8,276,000, or 17.8% of net sales.

Selling and marketing expenses totaled $2,614,000 in fiscal 2003, or 4.5% as a percentage of net sales, as compared to $2,547,000 or 5.5% of net sales in fiscal 2002. The slight increase in selling and marketing costs is primarily the result of higher commission expenses due to higher sales.

General and administrative expenses totaled $5,472,000 or 9.5% of sales as compared to $5,729,000 or 12.3% of sales. The decrease in general and administrative expenses is primarily attributable to certain non-recurring expenses in 2002 associated with facility maintenance and recruitment fees.

Other Income (Expense). Other income (expense) for fiscal 2003 was $110,000 as compared to $269,000 in fiscal 2002, a decrease of $159,000, or 59%. This decrease was due to decreased interest income as a result of lower interest rates.

Provision for Income Taxes. The income tax provision for fiscal 2003 was $583,000 compared to zero in the prior year. The effective rate differs from the federal statutory rate due to certain expenses not deductible for federal tax purposes and state taxes. At July 31, 2003, the Company had a valuation allowance of approximately $2.0 million against a portion of its net deferred tax assets. To the extent that the Company generates sufficient taxable ordinary income in the future, the valuation allowance may be reduced. Should the Company not generate sufficient taxable income in the future, the valuation allowance may need to be increased. Approximately $1.4 million of the valuation allowance would only be reversed and reflected as a reduction

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of income tax expense if the Company generates qualifying capital gain income, which we do not expect to occur in the foreseeable future.

Year Ended July 31, 2002 Compared to Year Ended July 31, 2001

Net Sales. Net sales for the fiscal year ended July 31, 2002 totaled $46,446,000, a decrease of $11,267,000 or 20% from fiscal 2001 net sales of $57,713,000. The decrease in sales was primarily the result of decreased sales in action sport products and protective products partially offset by an increase in outdoor products.

Gross sales in the action sports category (which includes in-line skates, skateboards and scooters) decreased $12,900,000 from $29,500,000 in fiscal 2001 to $16,600,000 in fiscal 2002 primarily as a result of the Company dropping the scooter business, which contributed over $8 million in fiscal 2001. In addition, gross sales for in-line skates and skateboards decreased in 2002 by 22% and 25% respectively, primarily due to lower volume sales in these products as a result of the consumer spending slowdown that caused many retailers to be extremely cautious and to manage their inventory levels downward.

Gross sales of protective products (which include recreational protective equipment such as wrist guards, elbow pads, knee pads and helmets) decreased $5,049,000, or 55%, from $9,175,000 in fiscal 2001 to $4,126,000 in fiscal 2002. This was primarily due to lower sales on X-Games identified products as a result of the expiration of the Company’s right to sell X-Games products on March 31, 2002.

The overall decrease in gross sales was partially offset by an increase in gross sales of our outdoor products (which include canopies and springless trampolines). Gross sales of our outdoor products increased $5,717,000, or 25%, to $28,156,000 in 2002 from $22,439,000 in 2001. Canopies and trampolines when compared to fiscal 2001 showed increased sales of 25% and 27%, respectively.

Three customers in fiscal 2002 individually accounted for more than 10% of the Company’s gross sales. Collectively, these three customers accounted for approximately 40% of the Company sales compared to the prior year where only one customer (at 27%) exceeded 10%.

Gross Profit. Gross profit for the fiscal year ended July 31, 2002 decreased by $1,739,000 compared to the fiscal year ended July 31, 2001, representing a 19% decrease. The Company’s gross profit margin as a percentage of net sales was relatively flat at 15.8% in fiscal 2002, compared with 15.7% in fiscal 2001. Changes in product mix contributed to the relatively minimal change in gross profit. Outdoor products, specifically canopies, were sold at slightly higher gross profit margins. However, the increase in gross profit margin resulting from increased canopy sales was offset by lower gross profit margins on increased international direct sales and to a lesser degree over-all competitive pricing.

Operating Expenses. The Company’s operating expenses (consisting of selling and marketing expenses and general and administrative expenses) for fiscal 2002 totaled $8,276,000, or 17.8% of net sales. Operating expenses for fiscal 2001 were $7,914,000, or 13.7% of net sales.

Selling and marketing expenses totaled $2,547,000 in fiscal 2002, or 5.5% as a percentage of sales, as compared to $3,704,000 or 6.4% of sales in fiscal 2001. The lower costs in selling and marketing reflect decreased commission expense as a result of lower sales in fiscal 2002, lower employee wages from an unfilled position for a part of the year and lower promotional tradeshow expenses.

General and administrative expenses totaled $5,729,000 or 12.3% of sales as compared to $4,743,000 or 8.2% of sales. The increase in general and administrative expense is partially a result of increased emphasis by the Company on product development. Product development expense in fiscal 2002 amounted to $1,110,000 compared to $811,000 in the prior year. The increase in general and administrative expense also included increased facility costs and increased professional fees as a result of the Company having received a legal fee reimbursement in the previous year.

Other Income (Expense). Other income (expense) for fiscal 2002 was $269,000 as compared to $572,000 in fiscal 2001, a decrease of $303,000, or 53%. This decrease was primarily due to decreased interest income due to lower interest rates and lower cash balances held throughout the year.

Provision for Income Taxes. No provision or benefit for income taxes was recorded in fiscal 2002 due to the operating loss throughout the year and due to changes in the valuation allowance. As of July 31, 2002 the company had a valuation allowance of approximately $2,000,000 against its net deferred tax assets. Approximately $1,400,000 of the valuation allowance would only be reversed and reflected as a reduction of income tax expense if the Company generates qualifying capital gain income, which the Company does not expect to occur in the foreseeable future.

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Liquidity and Capital Resources

The Company funds its activities principally from cash flow generated from operations and a credit facility with an institutional lender. Cash and cash equivalents totaled $17,582,000 as of July 31, 2003, compared to $12,169,000 as of July 31, 2002. Cash equivalents are invested in money market funds which consist of investment-grade short-term instruments and government securities. The Company currently plans to continue investing cash equivalents in this manner. The increase in cash and cash equivalents of $5,413,000 was primarily due to the Company’s lower inventory balances and to a lesser extent decreased accounts receivable balances. Net working capital as of July 31, 2003 was $29,890,000, compared to $28,491,000 as of July 31, 2002, and the Company’s current ratio (which measures the liquidity of the Company by comparing the current assets as a percentage of current liabilities) was 5.2:1 as of July 31, 2003, compared to 4.6:1 as of July 31, 2002.

The Company has a credit agreement with a major bank providing a $9,000,000 revolving line of credit with separate sub-limits of $9,000,000 for the issuance of commercial letters of credit and $2,000,000 for actual cash borrowing. The agreement is secured by substantially all the assets of the Company and carries an interest rate equal to the banks “reference rate” which is equivalent to “prime” and offers certain Libor based interest options. The Company is in compliance with all monthly financial covenants called for in the credit agreement. Borrowings for letters of credit have varied, typically reaching the highest levels in the pre-Christmas periods and the spring seasons. The outstanding balance on letters of credit on July 31, 2003 was $379,000 leaving approximately $8,621,000 available for issuance of letters of credit, inclusive of a separate sub limit of $2,000,000 available for cash borrowings. Since the Company expects to finance its 2004 operations from operating cash flow and existing cash reserves, the Company does not anticipate borrowing cash available under the line throughout fiscal 2004. The current agreement expires May 1, 2005.

The Company had long-term debt of $620,000 as of July 31, 2003 compared to $739,000 as of July 31, 2002, with the decrease due to a $200,000 principal payment made in the first quarter, offset by accrued interest for the period. The long-term debt arose as a result of a patent that was purchased in April 2000 which involved a collapsible canopy with a telescoping roof support structure and is payable in installments of $200,000 each year, to be paid over an eight-year period with a final payment on August 1, 2007.

Future Liquidity and Financial Position

The Company intends to continue to focus upon building and maintaining its existing product lines. The Company also plans to continue to devote resources toward the pursuit and development of new products. In addition, management continues to explore the possibility of making selected acquisitions of other companies or products that would offer a strategic fit with the Company’s existing products and its sourcing and distribution channels in the mass market.

Management believes that its current cash position, funds available under existing banking arrangements, and cash generated from operations will be sufficient to meet the Company’s presently projected cash and working capital requirements for the next fiscal year assuming continued financial performance at present levels.

The following table summarizes the outstanding borrowings and long-term contractual obligations of Variflex, Inc. at July 31, 2003 and the effects such obligations are expected to have on liquidity and cash flow in future periods.

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Sensitivity

The Company does not believe that the fluctuation in the value of the dollar in relation to the currency of its suppliers has any significant material and adverse impact on the Company’s ability to purchase products at agreed upon prices. Typically, the Company and its suppliers negotiate prices in U.S. Dollars and payments to suppliers are also made in U.S. Dollars. Nonetheless, there can be no assurance that the value of the dollar will not have an impact upon the Company in the future, if it fluctuates against foreign currencies.

The Company’s exposure to market rate risk for changes in interest rates relates primarily to the Company’s investment in short-term instruments and money market funds.

Critical Accounting Policies

Use of Estimates - Financial statements prepared in accordance with generally accepted accounting principles require management to make estimates and judgments that affect amounts and disclosures reported in the financial statements. Actual results could differ from those estimates. Significant estimates made in preparing the consolidated financial statements include allowances made against accounts receivable, reserves taken against inventory, accruals for sales returns and allowances, warranty, product liability claims, and other litigation related matters.

Accounts Receivable - Accounts receivable consist primarily of amounts due to us from our normal business activities. The Company’s ability to collect outstanding receivables from our customers is critical to our operating performance and cash flows. We maintain an allowance for doubtful accounts to reflect the estimated future uncollectability of accounts receivable based on past collection history and specific risks that have been identified by reviewing current customer information.

Inventory - Inventories consist primarily of finished products purchased in bulk categories to be sold to our customers. We state our inventories at lower of cost or market. In assessing the ultimate realization of inventories, we are required to make judgments as to the future selling prices and demand requirements and compare that with the current or committed inventory levels. In addition, an allowance for obsolete inventory is maintained to reflect the expected net realizable value of inventory based on an evaluation of slow-moving products.

Revenue Recognition - We recognize revenue when products are shipped which is at the point in time risk of loss is transferred to the customer. Sales are shown net of estimated allowances for returns, discounts, and cooperative advertising.

Warranties/Returns - The Company records a liability for the estimated costs of product warranties and returns at the time revenue is recognized. The Company’s warranty and returns obligations are affected by product failure rates, material usage, and service delivery costs incurred in correcting a product failure. The estimate of costs to service its warranty and returns obligation is based on historical experience and expectation of future conditions. To the extent the Company experiences increased warranty claim and returns activity or increased costs with servicing those claims, its warranty and returns accrual will increase, resulting in decreased gross profit.

Product Liability - The Company is involved in various claims arising from the sale of products in the normal course of business. The Company carries product liability insurance on its products with the exception of one outstanding claim, which has the potential of not being covered by insurance as a result of a prior year insurance carrier declaring bankruptcy. Under its insurance policy, any settlements on product liability claims require the Company to pay a deductible, depending on the type of product.

Deferred Taxes - The Company records a valuation allowance to reduce tax assets to the amount that is more likely than not to be realized. Realization of our deferred tax assets is principally dependent upon our achievement of projected future taxable income. Our judgment regarding future profitability may change due to future market conditions and other factors. These changes, if any, may require possible material adjustments to these deferred tax asset balances.

Additional Factors That Could Affect Operating Results

The following factors, together with other information contained elsewhere herein, should be considered carefully in evaluating the Company and its business.

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Loss of a major customer would immediately and severely curtail distribution outlets. In the past three fiscal years, the Company has had several customers that accounted for a majority of the Company’s sales. As is customary in the industry, the Company generally does not have long-term contracts with any of its customers. The loss of, or a reduction in business from, any of its major customers would have a material and adverse effect on the Company’s business results of operations and financial condition. In addition, because a large percentage of the Company’s accounts receivables are due from the major customers, the failure of any of them to make payments with respect to its account would have a material and adverse effect on the Company’s results of operations and financial condition.

If we cannot control prices, our very price-sensitive customers will purchase from our competitors instead of us. The Company operates in a highly competitive environment and there are no significant technological or manufacturing barriers to entry for most product categories other than instant canopies and springless trampolines. While the Company believes that the principal competitive factors in its market are price, quality of product, brand recognition, accessibility and customer service, the Company’s primary customers, mass merchandisers, are extremely price sensitive. As a result, the Company must continually monitor and control its costs while refining its products to maintain its market position. There can be no assurance that the Company can continue to provide its products at prices which are competitive, or that it can continue to design and market products that appeal to consumers even if price competitive. Some of the Company’s current and potential competitors have longer operating histories, greater brand recognition and significantly greater financial, marketing and other resources than the Company. The Company also competes to a lesser degree with manufacturers who sell directly to our customers.

Consumer demand could shift away from our products. The Company must continually anticipate the emergence of, and adapt its products to, the popular demands of consumers. No assurance can be given, however, that consumer demand for the Company’s product categories in general, or the Company’s products in particular, will continue into the future. A reduction in the demand for these products could have a material and adverse effect on the Company’s results of operations.

Changes in government regulations could hurt the Company’s business. The consumer retail industry is regulated by many agencies including but not limited to, the Consumer Product Safety Commission and the California Department of Food and Agriculture Division of Measurement Standards. The nature of any new laws and regulations and the manner in which existing and new laws and regulations may be interpreted and enforced cannot be fully determined. The enforcement of existing laws and regulations and the adoption of any future laws or regulations might decrease the demand for the Company’s products, impose taxes or other costly technical requirements or otherwise increase the cost of doing business which could hurt the Company’s business. The Company cannot predict the impact, if any, that future regulation or regulatory changes may have on the Company’s business.

Fluctuations in the company’s quarterly operating results may negatively affect the Company’s stock price. The Company’s quarterly results may fluctuate from quarter to quarter in the future due to a variety of factors, not all of which are under the Company’s control. Some of the factors that could cause the Company’s revenues and operating results to fluctuate include the following:

It is possible that in some future periods the Company’s results of operations may fall below the expectations of public market analysts and investors. This could result in a decline in the value of the Company’s common stock.

Reliance on Foreign Suppliers to Source the Company’s Products. The Company’s products are primarily sourced from suppliers located in Asia with whom the Company does not have long-term contractual agreements. If the Company

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were unable to develop and maintain relationships with suppliers that would allow it to obtain sufficient quantities of merchandise on acceptable commercial terms, its business, prospects, financial condition and results of operations would be materially and adversely affected. Moreover, the Company may not be able to obtain its products and supplies on substantially similar terms, including cost, in order to sustain its operating margins. Although management presently believes that other suppliers could be obtained in such instances, there can be no assurance that the Company would be able to obtain products and supplies on substantially similar terms, including cost, in the future. In addition, purchasing products from foreign suppliers subjects the Company to the general risks of doing business abroad. These risks include potential delays in shipment, work stoppages, adverse fluctuations in currency exchange rates, changes in import duties and tariffs, changes in foreign regulations and political instability.

A significant portion of the Company’s products, including various models of its in-line skates, are manufactured in mainland China, which trades with the United States under a Normal Trade Relations (“NTR”) trade status. While the Company believes that alternative manufacturing sources could be found, maintaining existing costs will depend upon these products continuing to be treated under NTR tariff rates. From time to time, the U.S. has threatened to rescind NTR tariff rates and impose trade sanctions on certain goods manufactured in China. To date, no such sanctions have been imposed that have affected the Company or its products; however there can be no assurance with regard to the possible imposition of sanctions in the future.

In addition, economic conditions in Asia could have a material and adverse impact upon the Company’s ability to procure products from suppliers. Any economic and financial difficulties experienced in Asia could cause a delay or inability to procure products from the Company’s suppliers which could have a material adverse effect on its business, operating results and financial condition

The Company’s product mix subjects it to potentially large product liability claims. Due to the nature of its products, the Company is subject to product liability claims, including claims for serious personal injury or death. Coverage is on a claims-made basis, and is subject to certain deductibles. Although the Company believes that it has adequate liability insurance for risks arising in the normal course of business, including product liability insurance with respect to all of its products, there can be no assurance that insurance coverage will be sufficient to cover one or more large claims or that the applicable insurer will be solvent at the time of any covered loss. Further, there can be no assurance that the Company will be able to obtain insurance coverage at acceptable levels and cost in the future. Successful assertion against the Company of one or a series of large claims, or of one or a series of claims exceeding any insurance coverage, could have a material and adverse effect on the Company’s results of operations and financial condition.

Our expenses could increase dramatically in defense of, or due to the loss of, any of our trademarks and proprietary rights. There are risks inherent in the design and development of new products and product enhancements, including those associated with patent issues and marketability. Potential liability from patent and other intellectual property infringements can have a material and adverse effect on the Company’s business, financial condition, results of operations or cash flows.

With respect to the Company’s own patents, service marks, trademarks, trade secrets and similar intellectual property, the Company considers such proprietary rights as critical to its success, and relies on patent and trademark law, trade secret protection and confidentiality and/or license agreements with its employees, customers, partners and others to protect its proprietary rights. The Company holds or has pending certain design patents and utility patents and employs various trademarks, trade names, including its own logos, in the packaging and advertising of its products. The Company has registered the Variflex^®, VFX^®, Static^®, Quik Shade^® and Airzone^™ trademarks in the United States, and actively protects against any unauthorized use in any other parts of the world. Registration of various other trademarks of the Company’s products are pending.

Enforcing our intellectual property rights, including through litigation, could result in substantial costs that could have a material adverse effect on the Company’s results of operation and financial condition. In addition, effective patent, trademark, service mark and trade secret protection may not be available in every country in which the Company’s products and services are made available. There can be no assurance that the steps taken by the Company to protect its proprietary rights will be adequate or that third parties will not infringe or misappropriate the Company’s patents, trademarks and similar proprietary rights. In addition, there can be no assurance that other parties will not assert infringement claims against the Company. The Company has been subject to claims and expects to be subject to legal proceedings and claims from time to time in the ordinary course of its business, including claims of alleged infringement of the trademarks and other intellectual property rights of third parties by the Company. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources.

Current brand licenses generally expire within two and a half years. Any extension or modification of these licenses is subject to the approval of both the licensor and Variflex. The loss or expiration of any of our larger revenue generating licenses could require us to immediately discontinue sales that account for a significant amount of revenues.

Our expansion into new business areas might not be cost effective. The Company is expanding its operations by developing and promoting new or complementary products, expanding the breadth and depth of products and services offered or expanding the acquisition of new or complementary businesses, products or technologies. There can be no assurance that the

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Company would be able to expand its efforts and operations in a cost-effective or timely manner or that any such efforts would increase overall market acceptance. Furthermore, any new business or product line launched by the Company that is not favorably received by consumers could damage the Company’s reputation or its various brand names. Expansion of the Company’s operations in this manner would also require significant additional development and operations expenses and would strain the Company’s management, financial and operational resources. The lack of market acceptance of such efforts or the Company’s inability to generate satisfactory revenues from such expanded businesses or products to offset their cost could have a material and adverse effect on the Company’s business, prospects, financial condition and results of operations.

We are dependent on key personnel. The Company’s performance is substantially dependent on the continued services and on the performance of its senior management and other key personnel, particularly Raymond (Jay) H. Losi II, who has entered into an employment agreement with the Company, which currently is on a month-to-month basis. The loss of Mr. Losi II could have a material and adverse effect on the Company. Although the Company carries a $5,000,000 life insurance policy on Mr. Losi II, no assurance can be given that the proceeds will be sufficient to protect against such a loss. The Company’s performance also depends on the Company’s ability to retain and motivate its other officers and key employees. The loss of the services of any of its executive officers or other key employees could have a material and adverse effect on the Company’s business, prospects, financial condition, and results of operations. Other than the aforementioned exceptions, the Company has long-term employment agreements with only a few of its key personnel. The Company’s future success also depends on its ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, merchandising, marketing and customer service personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be able to successfully attract, assimilate or retain sufficiently qualified personnel. The failure to retain and attract the necessary technical, managerial, merchandising, marketing and customer service personnel could have a material and adverse effect on the Company’s business, prospects, financial condition and results of operations.

A product recall on one of our products could require us to take an unanticipated charge. Certain of the Company’s products are subject to regulation by the Federal Consumer Products Safety Commission (the “CPSC”), and may therefore be subject to recall request by the CPSC. In October 2000, the Company announced that it was voluntarily recalling certain of its X Games helmets that did not comply with all applicable CPSC standards. This recall was completed in fiscal 2001. In fiscal 2000, the Company recorded an estimated product recall charge relating to these helmets, which was adjusted downward in fiscal 2001. Although the Company is not aware of any current proceeding by the CPSC that would result in the recall of the Company’s products, any such proceeding could have a material and adverse effect on the Company’s business, prospects, financial condition and results of operations.

The Company is exposed to changes in interest rates primarily from its investments in short-term instruments and money market funds. These investments are subject to risks associated with the level of volatility within the various financial markets, changes in interest rates, the condition of the United States and world economies and many other factors. The Company also has interest rate sensitivity related to its revolving direct advance line of credit. The Company currently has no derivative financial instruments. As of July 31, 2003, a 10% change in interest rates would not have had a material effect on our results of operations, financial position or cash flows.

The financial statements and schedules included herein are listed in Item 14.

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REPORT OF INDEPENDENT AUDITORS

The Board of Directors

Variflex, Inc.

We have audited the accompanying consolidated balance sheets of Variflex, Inc. (the Company) as of July 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended July 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 14. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Variflex, Inc. at July 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended July 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

/s/    ERNST & YOUNG                     

Woodland Hills, California

September 19, 2003

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VARIFLEX, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

See accompanying notes.

15

VARIFLEX, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

See accompanying notes.

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See accompanying notes.

17

VARIFLEX, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes.

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VARIFLEX, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

July 31, 2003

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation

The consolidated financial statements include the accounts of Variflex, Inc., a Delaware corporation and its two wholly owned subsidiaries (which have been closed and are currently inactive), Oketa Limited (Oketa), a Hong Kong corporation, and Static Snowboards, Inc., a Delaware corporation (collectively, the Company). The Company markets and distributes in-line skates, skateboards, recreational protective equipment (such as knee pads, elbow pads and wrist guards) and helmets, portable instant canopies, trampolines and other products. The Company designs and develops these products which are then manufactured to the Company’s specifications by independent contractors. The Company’s products are sold, primarily in the United States, to retailers, with some sales to wholesalers and distributors. All significant intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

Financial statements prepared in accordance with generally accepted accounting principles require management to make estimates and judgments that affect amounts and disclosures reported in the financial statements. Actual results could differ from those estimates. Significant estimates made in preparing the consolidated financial statements include allowances made against accounts receivable, reserves taken against inventory, accruals for sales returns and allowances, warranty, product liability claims, other litigation related matters, and the accrual for the product recall charge discussed in Note 14.

Revenue Recognition and Returns and Allowances

The Company recognizes revenue from product sales upon shipment which is at the point in time when risk of loss is transferred to the customer, net of estimated returns and allowances. The Company has established programs with its customers which enable them to receive credit for defective merchandise covered under its warranty policy. The Company’s products are under warranty against defects in material and workmanship for varying periods from date of purchase. The amount of potential credits is estimated and provided for in the period of sale.

In addition, the Company has certain cooperative advertising programs with its customers. In accordance with Emerging Issue Task Force 00-25, “Vendor Income Statement Characterization of Consideration from a Vendor to a Retailer”, the Company records the cooperative advertising expenditures as a reduction of revenue. Cooperative advertising expenditures are recorded at the time of revenue recognition.

Cost of Goods Sold

Cost of goods sold consist of product costs, freight distribution costs, warehouse costs, payroll expense, facility costs and other product related costs such as warranty expense and royalty fees.

The Company records freight and handling charges billed to customers in net sales and records related freight and handling costs in cost of goods sold.

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Concentration of Risk

The Company performs periodic evaluation of the credit worthiness of its customers and generally does not require collateral. Credit losses relating to the Company’s customers, mainly mass merchant retailers, have consistently been within management’s expectations and are provided for in the financial statements.

The Company operates within one industry segment where certain customers represent a significant portion of the Company’s business. Sales to the Company’s largest customers which have each individually accounted for more than 10% of the Company’s sales as a percentage of consolidated gross sales, were 18%, 17%, 13%, and 11% during fiscal 2003, 15%, 14% and 11% during fiscal 2002; and 27% for one customer during fiscal 2001. Receivables from three customers as a percentage of the Company’s total trade account receivable were 24%, 20% and 11% at July 31, 2003.

The Company’s products are sourced from independent contractors located primarily in Asia. These suppliers manufacture, assemble and package the Company’s products under the detailed specifications of the Company’s management representatives who visit frequently to oversee quality control and work on cost containment. The Company submits purchase orders to its manufacturers for the production of specific amounts of its products and has not entered into any long-term contractual agreements. The Company negotiates the cost of its products directly with its foreign suppliers in U.S. Dollars.

A significant portion of the Company’s products are manufactured in mainland China, which trades with the United States under a Normal Trade Relations (“NTR”) trade status. While the Company believes that alternative manufacturing sources could be found, maintaining existing costs will depend upon these products continuing to be treated under NTR tariff rates. From time to time, the U.S. has threatened to rescind NTR tariff rates and impose trade sanctions on certain goods manufactured in China. To date, no such sanctions have been imposed that have affected the Company or its products; however there can be no assurance with regard to the possible imposition of sanctions in the future.

Cash Equivalents

Short-term investments and money market funds with original maturities of three months or less are classified as cash equivalents. The carrying value of cash equivalents approximates market value.

Inventory

Inventory is stated at the lower of cost (first-in, first-out method) or market and consists of the following:

Long Lived Assets

In accordance with FASB Statement No. 144, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, the Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. The impairment loss is measured by comparing the fair value of the asset to its carrying amount.

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Property and Equipment

Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives (two to seven years) of the related assets or, for leasehold improvements, over the terms of the related leases, if shorter. Depreciation expense for the fiscal years ended July 31, 2003, 2002 and 2001 amounted to $104,000, $96,000 and $121,000, respectively.

Intangible Assets

The springless trampoline license agreement described in Note 9 is amortized on a straight-line basis over a period of 8 years and is included net of accumulated amortization as a component of intangible assets. Accumulated amortization of this license agreement as of July 31, 2003 and 2002 amounted to $521,000 and $396,000, respectively. The total cost recorded for the license agreement was $1,000,000 at July 31, 2003 and 2002.

The patent described in Note 10 is amortized on a straight-line basis over a period of 7.25 years and is included net of accumulated amortization as a component of intangible assets. Accumulated amortization of patents as of July 31, 2003 and 2002 amounted to $1,148,000 and $794,000, respectively. The total cost recorded for the patent was $2,560,000 at July 31, 2003 and 2002.

The estimated aggregate amortization expense for each of the five succeeding fiscal years will be $478,000, $478,000, $478,000, $457,000, and zero, respectively.

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed based on the weighted average number of shares of common stock outstanding during the period. Dilutive earnings (loss) per share is based on the weighted average number of shares of common stock outstanding, and common stock equivalents, when dilutive. Common stock equivalents represent the dilutive effect of the assumed exercise of certain outstanding options and warrants. For the years ended July 31, 2003 and 2001, the number of shares used in the calculation of diluted earnings per share included 11,000 and 212,501 shares, respectively, issuable under stock options and warrants using the treasury stock method. Common stock equivalents are excluded from the computation for the year ended July 31, 2002 because their effect is antidilutive.

Advertising Costs

Cooperative advertising expense is charged against gross sales and for the years ended July 31, 2003, 2002 and 2001 amounted to $888,000, $1,323,000 and $2,317,000, respectively.

Stock Based Compensation

Employee stock options are accounted for under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as amended and interpreted, which requires recognition of expense when the option price is less that the fair value of the stock at the date of grant. The Company generally awards options for a fixed number of shares at an option price equal to the fair value of the stock at the date of the grant. The Company has adopted the disclosure-only provisions of the Financial Accounting Standards Board’s Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) as amended by SFAS No. 148, “Accounting for Stock-based Compensation – Transitional Disclosure”.

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If the Company recognized employee stock option related compensation expense in accordance with SFAS 123 and used the Black-Scholes model for determining the weighted average fair value of options granted, the Company’s net income and earnings per share would have been reduced to the pro forma amounts indicated below:

Comprehensive Income

During the years ending July 31, 2003, 2002 and 2001 comprehensive income (loss) was the same as net income or loss.

Product Development

Product development costs are included in general and administrative costs and are expensed as incurred. Product development costs were $1,261,000, $1,110,000, and $810,000 in the years ended July 31, 2003, 2002 and 2001, respectively.

Segment Reporting

Pursuant to Statement of Financial Accounting Standards No. 131 (“SFAS No. 131”), “Disclosure about Segments of an Enterprise and Related Information,” the Company has determined, based on its internal system of management reporting and since it assesses performance as a single operating unit, that in the years ended July 31, 2003, 2002 and 2001, it operated in only one segment.

Gross sales of similar products for the single segment are as follows: