UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-QSB

(Mark One)

þ		QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

o		TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from                      to                     

Commission file number: 0-17363

LIFEWAY FOODS, INC.

(Exact name of small business issuer as specified in it charter)

Illinois		36-3442829
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

6431 WEST OAKTON, MORTON GROVE, ILLINOIS 60053
(Address of principal executive offices)

(847) 967-1010

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or such shorter period that the issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No o

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: As of September 30, 2006, the issuer had 16,855,889 shares of common stock, no par value, outstanding.

Transitional Small Business Disclosure Format (Check one): Yes o No þ

 

 

INDEX

PART I — FINANCIAL INFORMATION			3
ITEM 1. FINANCIAL STATEMENTS			3
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION			20
ITEM 3. CONTROLS AND PROCEDURES			23
PART II — OTHER INFORMATION			23
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K			23
SIGNATURE			24
Section 302 Certification
Section 302 Certification
Section 1350 Certification
Section 1350 Certification

302 Certifications
Section 1350 Certifications

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LIFEWAY FOODS, INC. AND SUBSIDIARY

CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006 and 2005

AND DECEMBER 31, 2005

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Consolidated Statements of Financial Condition
September 30, 2006 and 2005 (Unaudited) and December 31, 2005

		(Unaudited)
		September 30,								December, 31
		2006				2005				2005
ASSETS
Current assets
Cash and cash equivalents		$	1,242,306			$	4,191,755			$	4,354,081
Marketable securities			8,042,189				7,580,531				7,478,697
Inventories			2,628,508				1,301,066				1,716,999
Accounts receivable, net of allowance for doubtful accounts of $45,000 and $15,000 at September 30, 2006 and 2005 and $35,000 at December 31, 2005			3,984,991				2,637,528				2,517,615
Prepaid expenses and other current assets			46,547				82,293				9,144
Other receivables			59,810				109,093				56,435
Deferred income taxes			108,154				46,881				142,772
Refundable income taxes			68,346				58,037				11,562
Total current assets			16,180,851				16,007,184				16,287,305
Property and equipment, net			8,574,181				7,755,352				7,751,446
Intangible assets
Goodwill			7,321,114				75,800				75,800
Other intangible assets, net of accumulated amortization of $142,010 and $59,379 at September 30, 2006 and 2005 and $92,432 at December 31, 2005			300,628				366,567				350,206
Total intangible assets			7,621,742				442,367				426,006
Total assets		$	32,376,774			$	24,204,903			$	24,464,757
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Current maturities of notes payable		$	1,124,284			$	534,938			$	532,454
Accounts payable			1,251,720				648,881				426,253
Accrued expenses			270,990				453,895				355,011
Total current liabilities			2,646,994				1,637,714				1,313,718
Notes payable			6,191,521				2,919,656				2,903,349
Deferred income taxes			346,217				362,314				348,923
Stockholders’ equity
Common stock			6,509,267				6,509,267				6,509,267
Paid-in-capital			1,080,911				82,738				90,725
Treasury stock, at cost			(1,235,542	)			(1,034,172	)			(1,024,659	)
Retained earnings			16,807,609				13,715,660				14,422,948
Accumulated other comprehensive income (loss), net of taxes			29,797				11,726				(99,514	)
Total stockholders’ equity			23,192,042				19,285,219				19,898,767
Total liabilities and stockholders’ equity		$	32,376,774			$	24,204,903			$	24,464,757

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Consolidated Statements of Income and Comprehensive Income
For the Three and Nine Months Ended September 30, 2006 and 2005 (Unaudited)
and The Year Ended December 31, 2005

		(Unaudited)								(Unaudited)
		Three Months Ended								Nine Months Ended								Year Ended
		September 30								September 30								December 31,
		2006				2005				2006				2005				2005
Sales		$	7,456,649			$	5,194,648			$	19,827,069			$	14,924,076			$	20,131,654
Cost of goods sold			4,599,428				3,073,314				11,550,612			$	8,607,538				11,664,065
Gross profit			2,857,221				2,121,334				8,276,457				6,316,538				8,467,589
Operating expenses			1,737,901				1,359,171				4,820,613			$	3,793,394				5,066,227
Income from operations			1,119,320				762,163				3,455,844				2,523,144				3,401,362
Other income (expense):
Interest and dividend income			86,318				72,363				294,583				212,927				323,365
Interest expense			(96,557	)			(36,877	)			(209,983	)			(51,195	)			(100,762	)
Gain (loss) on sale of marketable securities, net			89,260				162,446				277,674				324,433				445,327
Gain on marketable securities classified as trading			(2,370	)			(681	)			691				14,355				13,773
Total other income			76,651				197,251				362,965				500,520				681,703
Income before provision for income taxes			1,195,971				959,414				3,818,809				3,023,664				4,083,065
Provision for income taxes			456,012				400,464				1,434,148				1,182,479				1,534,592
Net income		$	739,959			$	558,950			$	2,384,661			$	1,841,185			$	2,548,473
Basic and diluted earnings per common share			0.04				0.03				0.14				0.11				0.15
Weighted average number of shares outstanding			16,860,139				16,786,768				16,855,889				16,815,536				16,808,992
COMPREHENSIVE INCOME
Net income		$	739,959			$	558,950			$	2,384,661			$	1,841,185			$	2,548,473
Other comprehensive income (loss), net of tax:
Unrealized gains (losses) on marketable securities (net of tax benefits)			102,436				103,458				312,717				82,988				42,708
Less reclassification adjustment for gains (losses) included in net income (net of taxes)			(73,184	)			(96,369	)			(183,406	)			(190,442	)			(261,402	)
Comprehensive income		$	769,211			$	566,039			$	2,513,972			$	1,733,731			$	2,329,779

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholder’s Equity
For the Nine Months Ended September 30, 2006 (Unaudited)
and the Year Ended December 31, 2005

		Common Stock,
		No Par Value																												Accumulated
		20,000,000 Shares								# of Shares																				Other
		Authorized								of																				Comprehensive
		# of Shares				# of Shares				Treasury				Common				Paid In				Treasury				Retained				Income (Loss),
		Issued				Outstanding				Stock				Stock				Capital				Stock				Earnings				Net of Tax				Total
Balances at December 31, 2004			17,273,776				16,882,876				390,900			$	6,509,267			$	64,314			$	(649,039	)		$	11,874,475			$	119,180			$	17,918,197
Issuance of treasury stock			—				7,634				(7,634	)			—				26,411				25,934				—				—				52,345
Redemption of stock			—				(100,000	)			100,000				—				—				(401,554	)			—				—				(401,554	)
Other comprehensive income (loss):
Unrealized losses on securities, net of taxes and reclassification adjustment			—				—				—				—				—				—				—				(218,694	)			(218,694	)
Net income for the year ended December 31, 2005			—				—				—				—				—				—				2,548,473				—				2,548,473
Balances at December 31, 2005			17,273,776				16,790,510				483,266			$	6,509,267			$	90,725			$	(1,024,659	)		$	14,422,948			$	(99,514	)		$	19,898,767
Issuance of treasury stock for compensation			—				4,666				(4,666	)			—				13,311				15,855				—				—				29,166
Issuance of treasury stock for acquisition of Helios			—				202,650				—				—				976,875				323,125				—				—				1,300,000
Redemption of stock			—				(89,682	)			89,682				—				—				(549,863	)			—				—				(549,863	)
Other comprehensive income (loss):
Unrealized gains on securities, net of taxes and reclassification adjustment			—				—				—				—				—				—				—				129,311				129,311
Net income for the nine months ended September 30, 2006			—				—				—				—				—				—				2,384,661				—				2,384,661
Balances at September 30, 2006			17,273,776				16,908,144				568,282			$	6,509,267			$	1,080,911			$	(1,235,542	)		$	16,807,609			$	29,797			$	23,192,042

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the Nine Months Ended September 30, 2006 and 2005 (Unaudited)
and the Year Ended December 31, 2005

		Nine Months Ended								Year Ended
		September 30,								December 31,
		2006				2005				2005
Cash flows from operating activities:
Net income		$	2,384,661			$	1,841,185			$	2,548,473
Adjustments to reconcile net income to net cash flows from operating activities, net of acquisition:
Depreciation and amortization			457,844				486,050				650,945
(Gain)Loss on sale of marketable securities, net			(277,674	)			(324,433	)			(445,327	)
Gain on marketable securities classified as trading			(691	)			(14,355	)			(13,773	)
Deferred income taxes			(58,932	)			(69,220	)			(100,236	)
Treasury stock issued for services			29,166				34,845				52,345
Increase in allowance for doubtful accounts			10,000								—
(Increase) decrease in operating assets:
Accounts receivable			(1,197,722	)			(613,492	)			(493,579	)
Other receivables			(3,375	)			(36,956	)			15,702
Inventories			(691,875	)			(395,369	)			(811,302	)
Refundable income taxes			(56,784	)			200,580				247,055
Prepaid expenses and other current assets			468				(75,033	)			(1,884	)
Increase (decrease) in operating liabilities:
Accounts payable			427,705				7,230				(215,398	)
Accrued expenses			(84,021	)			258,354				159,470
Net cash provided by operating activities			938,770				1,299,386				1,592,491
Cash flows from investing activities:
Purchases of marketable securities			(5,258,207	)			(5,149,008	)			(6,460,561	)
Sale of marketable securities			5,193,235				4,466,196				5,810,391
Purchases of property and equipment			(500,118	)			(4,772,181	)			(4,916,811	)
Acquisition of Helios, net of cash acquired			(2,514,679	)
Net cash used in investing activities			(3,079,769	)			(5,454,993	)			(5,566,981	)
Cash flows from financing activities:
Proceeds from note payable			—				3,000,000				3,000,000
Purchases of treasury stock			(549,863	)			(401,554	)			(401,554	)
Repayment of notes payable			(420,913	)			(17,731	)			(36,522	)
Loan costs			—				(6,638	)			(6,638	)
Net cash provided by (used in) financing activities			(970,776	)			2,574,077				2,555,286
Net decrease in cash and cash equivalents			(3,111,775	)			(1,581,530	)			(1,419,204	)
Cash and cash equivalents at the beginning of the period			4,354,081				5,773,285				5,773,285
Cash and cash equivalents at the end of the period		$	1,242,306			$	4,191,755			$	4,354,081

See accompanying notes to financial statements

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 1 – NATURE OF BUSINESS

Lifeway Foods, Inc. (The “Company”) commenced operations in February 1986 and incorporated under the laws of the state of Illinois on May 19, 1986. The Company’s principal business activity is the production of dairy products. Specifically, the Company produces Kefir, a drinkable product which is similar to but distinct from yogurt, in several flavors sold under the name “Lifeway’s Kefir;” a plain farmer’s cheese sold under the name “Lifeway’s Farmer’s Cheese;” a fruit sugar-flavored product similar in consistency to cream cheese sold under the name of “Sweet Kiss;” and a dairy beverage, similar to Kefir, with increased protein and calcium, sold under the name “Basics Plus.” The Company also produces several soy-based products under the name “Soy Treat” and a vegetable-based seasoning under the name “Golden Zesta.” The Company currently distributes its products throughout the Chicago Metropolitan area and various cities in the East Coast through local food stores. In addition, the products are sold throughout the United States and Ontario, Canada by distributors. The Company also distributes some of its products to Eastern Europe.

On August 3, 2006 the Company executed a Stock Purchase Agreement with George Economy, Amani Holdings, LLC and other shareholders (“the stockholders”) of the capital stock of Helios Nutrition, Ltd. (“Helios”) and Pride Main Street Dairy, L.L.C. pursuant to which the Company purchased all of the issued and outstanding stock of Helios from the Stockholders for a combination of an aggregate amount of 202,650 in shares of the Company’s common stock, no par value, $2,526,000 in cash, and a promissory note issued by the Company in favor of Amani Stockholders in the principal amount of $4,200,000. The Stock Payment, the Cash Payment and Promissory Note are subject to adjustment under certain circumstances in accordance with the terms of the Stock Purchase Agreement.

The final net purchase price for the assets was $8,026,000 including professional fees related to the acquisition. The following table summarizes the tentative estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition. The company is in the process of calculating a valuation of the identifiable intangible assets acquired; thus, the final purchase price allocation is subject to change:

Cash		$	11,321
Accounts Receivable Assumed			279,654
Inventories			219,634
Equipment, Building and Land			730,883
Prepaid Items			37,871
Goodwill and Amortizable Intangibles			7,245,314
Total Assets Acquired			8,524,677
Note Payable and Accounts Payable Assumed			(498,677	)
Net Assets Acquired		$	8,026,000

At closing, $2,526,000 was paid of the total purchase, $1,300,000 was paid in stock, with the balance due as a $4,200,000 note to be paid in sixteen equal installments over the next sixteen quarters.

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A summary of the significant accounting policies applied in the preparation of the accompanying financial statements follows:

Principles of consolidation

The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, LFI Enterprises, Inc., Helios Nutrition, Ltd. and Pride of Main Street Dairy, L.L.C. All significant intercompany accounts and transactions have been eliminated.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition

Sales represent sales of Company produced dairy products that are recorded at the time of shipment and the following four criteria have been met: (i) The product has been shipped and the Company has no significant remaining obligations; (ii) Persuasive evidence of an agreement exists; (iii) The price to the buyer is fixed or determinable and (iv) Collection is probable. In addition, shipping costs invoiced to the customers are included in net sales and the related cost in cost of sales.

Cash and cash equivalents

All highly liquid investments purchased with an original maturity of three months or less are considered to be cash equivalents.

The Company maintains cash deposits at several institutions located in the greater Chicago, Illinois and Philadelphia, Pennsylvania metropolitan areas. Deposits at each institution are insured up to $100,000 by the Federal Deposit Insurance Corporation or the Securities Investor Protector Corporation.

Bank balances of amounts reported by financial institutions are categorized as follows:

		September 30,								December 31
		2006				2005				2005
Amounts insured		$	392,445			$	500,000			$	462,571
Uninsured and uncollateralized amounts			1,101,926				3,959,945				4,331,179
Total bank balances		$	1,494,371			$	4,459,945			$	4,793,750

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – Continued

Marketable securities

All investment securities are classified as either as available-for-sale or trading, and are carried at fair value or quoted market prices. Unrealized gains and losses are reported as a separate component of stockholders’ equity. Amortization, accretion, interest and dividends, realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are recorded in other income. Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. This evaluation depends on the specific facts and circumstances. Factors that we consider in determining whether an other-than-temporary decline in value has occurred include: the market value of the security in relation to its cost basis; the financial condition of the investee; and the intent and ability to retain the investment for a sufficient period of time to allow for possible recovery in the market value of the investment.

Accounts receivable

Credit terms are extended to customers in the normal course of business. The Company performs ongoing credit evaluations of its customers’ financial condition and generally requires no collateral.

Accounts receivable are recorded at invoice amounts, and reduced to their estimated net realizable value by recognition of an allowance for doubtful accounts. The Company’s estimate of the allowance for doubtful accounts is based upon historical experience, its evaluation of the current status of specific receivables, and unusual circumstances, if any. Accounts are considered past due if payment is not made on a timely basis in accordance with the Company’s credit terms. Accounts considered uncollectible are charged against the allowance.

Inventories

Inventories are stated at the lower of cost or market, cost being determined by the first-in, first-out method.

Property and equipment

Property and equipment are stated at depreciated cost or fair value where depreciated cost is not recoverable. Depreciation is computed using the straight-line method. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts, and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to income as incurred; significant renewals and betterments are capitalized.

Property and equipment are being depreciated over the following useful lives:

Category		Years
Buildings and improvements		31 and 39
Machinery and equipment		5 – 12
Office equipment		5 – 7
Vehicles			5

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – Continued

Intangible assets

The Company accounts for intangible assets at historical cost. Intangible assets acquired in a business combination are recorded under the purchase method of accounting at their estimated fair values at the date of acquisition. Goodwill represents the excess purchase price over the fair value of the net tangible and other intangible assets acquired. Goodwill related to the acquisition of Helios is subject to change based on the fair value calculated in the final purchase price allocation. Goodwill is not amortized and is reviewed for impairment at least annually. The Company amortizes other intangible assets over their estimated useful lives, as disclosed in the table below.

The Company reviews intangible assets and their related useful lives at least once a year to determine if any adverse conditions exist that would indicate the carrying value of these assets may not be recoverable. The Company conducts more frequent impairment assessments if certain conditions exist, including: a change in the competitive landscape, any internal decisions to pursue new or different strategies, a loss of a significant customer, or a significant change in the market place including changes in the prices paid for the Company’s products or changes in the size of the market for the Company’s products.

If the estimate of an intangible asset’s remaining useful life is changed, the remaining carrying amount of the intangible asset is amortized prospectively over the revised remaining useful life.

Intangible assets are being amortized over the following useful lives:

Category		Years
Recipes		4
Customer lists and other customer related intangibles		8
Lease agreement		7

Income taxes

Deferred income taxes arise from temporary differences resulting from income and expense items reported for financial accounting and tax purposes in different periods. Deferred taxes are classified as current or non-current, depending on the classification of the assets and liabilities to which they relate. Deferred taxes arising from temporary differences that are not related to an asset or liability are classified as current or non-current depending on the periods in which the temporary differences are expected to reverse.

The principal sources of temporary differences are different depreciation and amortization methods for financial statement and tax purposes, unrealized gains or losses related to marketable securities, capitalization of indirect costs for tax purposes, and the recognition of an allowance for doubtful accounts for financial statement purposes.

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – Continued

Treasury stock

Treasury stock is recorded using the cost method.

Advertising costs

The Company expenses advertising costs as incurred. During the year ended December 31, 2005 and for the nine months ended September 30, 2006 and 2005, approximately $1,176,440, $1,092,560 and $914,598 of such costs respectively, were expensed.

Earning per common share

Earnings per common share were computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. For the nine months ended September 30, 2006 and 2005 and the year ended December 31, 2005, diluted and basic earnings per share were the same, as the effect of dilutive securities options outstanding was not significant.

Note 3 – INTANGIBLE ASSETS

     Intangible assets, and the related accumulated amortization, consist of the following:

		September 30, 2006								September 30, 2005								December 31, 2005
						Accumulated								Accumulated								Accumulated
		Cost				Amortization				Cost				Amortization				Cost				Amortization
Recipes		$	43,600			$	23,617			$	43,600			$	12,717			$	43,600			$	15,442
Customer lists and other customer related intangibles			305,200				89,743				305,200				48,323				305,200				58,678
Lease acquisition			87,200				26,990				87,200				14,533				87,200				17,648
Goodwill			7,321,114				—				75,800				—				75,800				—
Loan acquisition costs			6,638				1,660				6,638				498				6,638				664
		$	7,763,752			$	142,010			$	518,438			$	76,071			$	518,438			$	92,432

     Amortization expense is expected to be as follows for the 12 months ending September 30:

2007		$	66,105
2008			66,105
2009			56,113
2010			47,211
2011			45,157
Thereafter			19,937
		$	300,628

Amortization expense during the nine months ended September, 2006 and 2005 and the year ended December 31, 2005 was $49,579, $49,081 and $65,442, respectively.

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
And December 31, 2005

Note 4 – MARKETABLE SECURITIES

The cost and fair value of marketable securities classified as available for sale and trading are as follows:

														Loss on
														Marketable
														Securities
						Unrealized				Unrealized				Classified as				Fair
September 30, 2006		Cost				Gains				Losses				Trading				Value
Equities		$	2,918,943			$	249,781			$	(150,197	)						$	3,018,527
Mutual Funds			288,630				2,447				(3,666	)							287,411
Preferred Securities			1,491,741				5,214				(28,560	)							1,468,395
Private Investment LP			600,000				42,660				—								642,660
Certificates of Deposit			225,000				1,305				(2,393	)							223,912
Corporate Bonds			2,153,896				3,238				(70,694	)							2,086,440
Municipal Bonds			160,757				1,828				(203	)							162,382
Government agency			154,483				—				—				(2,021	)			152,462
Total		$	7,993,450			$	306,473			$	(255,713	)			(2,021	)		$	8,042,189

														Loss on
														Marketable
														Securities
						Unrealized				Unrealized				Classified as				Fair
September 30, 2005		Cost				Gains				Losses				Trading				Value
Equities and Mutual Funds		$	4,136,818			$	221,349			$	(121,835	)			—			$	4,236,332
Preferred Securities			955,233								(19,849	)			—				935,384
Certificates of Deposit			150,000								(3,630	)			—				146,370
Corporate Bonds			2,159,363								(55,732	)			—				2,103,631
Municipal bonds			61,275				1,012				(1,341	)			—				60,946
Government agency			100,000				—				—				(2,132	)			97,868
Total		$	7,562,689			$	222,361			$	(202,387	)		$	(2,132	)		$	7,580,531

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 4 – MARKETABLE SECURITIES – Continued

														Loss on
														Marketable
														Securities
						Unrealized				Unrealized				Classified as				Fair
December 31, 2005		Cost				Gains				Losses				Trading				Value
Equities		$	2,432,964			$	212,336				(198,478	)			—			$	2,446,822
Mutual Funds			699,921				3,770				(74,148	)			—				629,543
Preferred Securities			1,002,738				1,468				(30,892	)			—				973,314
Private Investment LP			600,000				—				(5,146	)			—				594,854
Certificates of Deposit			240,000				—				(1,125	)			—				238,875
Corporate Bonds			2,514,044				809				(77,888	)			—				2,436,965
Municipal Bonds, maturing within five years			61,275				957				(1,195	)			—				61,037
Government agency obligations, maturing after five years			100,000				—				—				(2,713	)			97,287
Total		$	7,650,942			$	219,340			$	(388,872	)		$	(2,713	)		$	7,478,697

Proceeds from the sale of marketable securities were $5,810,391, $5,196,300 and $4,466,196 during the year ended December 31, 2005 and for the nine months ended September 30, 2006 and 2005, respectively.

Gross gains of $445,327, $277,674 and $324,433 were realized on these sales during the year ended December 31, 2005 and for the nine months ended September 30, 2006 and 2005, respectively.

The following table shows the gross unrealized losses and fair value of Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2006:

		Less Than 12 Months								12 Months or Greater								Total
Description of						Unrealized								Unrealized								Unrealized
Securities		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
Equities		$	903,773			$	(107,132	)		$	205,404			$	(43,065	)		$	1,109,177			$	(150,197	)
Mutual Funds			10,710				(566	)			96,900				(3,100	)			107,610				(3,666	)
Preferred Securities			330,360				(3,115	)			682,405				(25,445	)			1,012,765				(28,560	)
Certificates of Deposit			72,607				(2,393	)			—				—				72,607				(2,393	)
Corporate Bonds			711,128				(24,186	)			861,227				(46,508	)			1,572,355				(70,694	)
Municipal Bonds			—				—				19,802				(203	)			19,802				(203	)
		$	2,028,578			$	(137,392	)		$	1,865,738			$	(118,321	)		$	3,894,316				(255,713	)

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 4 – MARKETABLE SECURITIES – Continued

Equities, Mutual Funds and Corporate Bonds — The Company’s investments in equity securities, mutual funds and corporate bonds consist of investments in common stock and debt securities of companies in various industries. The Company evaluated the near-term prospects of the issuer in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider any material investments to be other-than-temporarily impaired at September 30, 2006.

Preferred Securities — The Company’s investments in preferred securities consist of investments in preferred stock of companies in various industries. The Company evaluated the near-term prospects of the security in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider any material investments to be other-than-temporarily impaired at September 30, 2006.

Private Investment Limited Partnership — The Company’s investments in private limited partnerships consist of one limited partnership interest. The Company evaluated the near-term prospects of the investment in relation to the severity and duration of the impairment. Based on that evaluation and the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider it’s investment to be other-than-temporarily impaired at September 30, 2006.

Certificates of Deposit — The unrealized losses on the Company’s investments in certificates of deposit were caused by interest rate increases since the date of purchase. The contractual terms of these investments do not permit the issuers to settle the securities at a price less than the face value of the investment. Because the Company has the ability and intent to hold these investments until maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2006.

Municipal Bonds — The unrealized losses on the Company’s investments in mutual bonds were caused by interest rate increases since the date of purchase. Because the Company has the ability and intent to hold these investments until maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2006.

Note 5 – INVENTORIES

     Inventories consist of the following:

		September 30,								December 31,
		2006				2005				2005
Finished goods		$	988,212			$	537,514			$	658,522
Production supplies			905,615				460,664				662,310
Raw materials			734,681				302,888				396,167
Total inventories		$	2,628,508			$	1,301,066			$	1,716,999

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 6 – PROPERTY AND EQUIPMENT

     Property and equipment consist of the following:

		September 30,								December 31,
		2006				2005				2005
Land		$	969,232			$	909,232			$	909,232
Buildings and improvements			6,715,371				6,441,412				6,443,043
Machinery and equipment			6,961,853				5,667,016				5,806,853
Vehicles			534,365				510,510				513,670
Office equipment			89,192				78,763				78,763
			15,270,013				13,606,938				13,751,561
Less accumulated depreciation			6,695,832				5,851,581				6,000,115
Total property and equipment		$	8,574,181			$	7,755,352			$	7,751,446

Depreciation expense during the year ended December 31, 2005 and for the nine months ended September 30, 2006 and 2005 was $585,503, $408,266 and $436,969, respectively.

Note 7 – ACCRUED EXPENSES

     Accrued expenses consist of the following:

		September 30,								December 31,
		2006				2005				2005
Accrued payroll and payroll taxes		$	34,979			$	135,090			$	104,873
Accrued property tax			202,080				312,112				244,916
Other			33,931				6,693				5,222
		$	270,990			$	453,895			$	355,011

Note 8 – NOTES PAYABLE

     Notes payable consist of the following:

		September 30,								December 31,
		2006				2005				2005
Mortgage note payable to a bank, payable in monthly installments of $3,273 including interest at 7%, with a balloon payment of $416,825 due September 25, 2011. Collateralized by real estate.		$	455,079			$	465,179			$	462,695
Mortgage note payable to a bank, payable in monthly installments of $19,513 including interest at 5.6%, with a balloon payment of $2,652,143 due July 14, 2010. Collateralized by real estate.			2,923,226				2,989,415				2,973,108
Note payable to Amani Holding LLC, payable in quarterly installments of $262,500 plus interest at the floating prime rate per annum due September 1, 2010 secured by letter of credit			3,937,500				—				—
Total notes payable			7,315,805				3,454,594				3,435,803
Less current maturities			1,124,284				534,938				532,454
Total long-term portion		$	6,191,521			$	2,919,656			$	2,903,349

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 8 – NOTES PAYABLE – Continued

     Maturities of notes payables are as follows:

For the year ended September 30,
2007		$	1,124,284
2008			1,125,226
2009			1,126,597
2010			3,522,873
2011			416,825
Total		$	7,315,805

Note 9 – PROVISION FOR INCOME TAXES

     The provision for income taxes consists of the following:

										For the
		For the Nine Months Ended								Year Ended
		September 30,								December 31,
		2006				2005				2005
Current:
Federal		$	1,203,942			$	1,050,319			$	1,364,033
State and local			289,274				201,380				270,795
Total current			1,493,216				1,251,699				1,634,828
Deferred			(59,068	)			(69,220	)			(100,236	)
Provision for income taxes		$	1,434,148			$	1,182,479			$	1,534,592

A reconciliation of the provision for income taxes and the income tax computed at the statutory rate is as follows:

										For The
		For The Nine Months Ended								Year Ended
		September 30,								December 31,
		2006				2005				2005
Federal income tax expense computed at the statutory rate		$	1,298,395			$	1,028,045			$	1,388,242
State and local tax expense, net			183,268				145,136				195,987
Permanent differences			(47,515	)			9,298				(49,637	)
Provision for income taxes		$	1,434,148			$	1,182,479			$	1,534,592

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 9 – PROVISION FOR INCOME TAXES – Continued

     Amounts for deferred tax assets and liabilities are as follows:

		September 30,								December 31
		2006				2005				2005
Non-current deferred tax liabilities arising from:
Temporary differences — accumulated depreciation		$	(346,217	)		$	(362,314	)		$	(348,923	)
Current deferred tax assets (liabilities) arising from:
Unrealized losses (gains) on marketable securities			(20,965	)			(8,250	)			70,016
Inventory			110,533				55,131				72,756
Allowance for doubtful accounts			18,585				—				—
Total current deferred tax assets (liabilities)			108,153				46,881				142,772
Net deferred tax liability		$	(238,064	)		$	(315,433	)		$	(206,151	)

Note 10 – SUPPLEMENTAL CASH FLOW INFORMATION

     Cash paid for interest and income taxes are as follows:

										For Year
		For the Nine Months Ended								Ended
		September 30,								December 31,
		2006				2005				2005
Interest		$	209,983			$	51,195			$	100,762
Income taxes		$	1,555,444			$	1,053,064			$	1,425,600

The Company had the following non-cash investing and financing activities during the period. As described in Note 1, the Company issued 202,650 shares of common stock with a fair value of $1,300,000 and a promissory note in the principal amount of $4,200,000 as partial consideration for the acquisition of Helios.

Note 11 – STOCK OPTION PLANS

The Company has a registration statement filed with the Securities and Exchange Commission in connection with a Consulting Service Compensation Plan covering up to 600,000 of the Company’s common stock shares. Pursuant to such Plan, the Company may issue common stock or options to purchase common stock to certain consultants, service providers, and employees of the Company. There were 468,000 shares available for issuance under the Plan at December 31, 2005 and at September 30, 2006 and 2005. The option price, number of shares, grant date, and vesting terms are determined at the discretion of the Company’s Board of Directors.

As of December 31, 2005 and at September 30, 2006 and 2005, there were no stock options outstanding or exercisable.

LIFEWAY FOODS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
September 30, 2006 and 2005
and December 31, 2005

Note 11 – STOCK OPTION PLANS – Continued

On February 12, 2004, Lifeway’s Board of Directors approved awards of an aggregate amount of 10,200 shares to be awarded under its Employee and Consulting Services and Compensation Plan to certain employees and consultants for services rendered to the Company. The stock awards were made on April 1, 2004 and have vesting periods that vary from six months to one year, depending upon the individual grantee. During 2005, 550 shares vested for a total expense of $11,512.

On May 23, 2005, Lifeway’s Board of Directors approved awards of an aggregate amount of 11,200 common shares to be awarded under its Employee and Consulting Services and Compensation Plan to certain employees and consultants for services rendered to the Company. The stock awards were made on June 1, 2005 and have vesting periods of one year. The expense for the awards is measured as of June 1, 2005 at $6.25 per share for 11,200 shares, or a total stock award expense of $70,000. This expense will be recognized as the stock awards vest in 12 equal portions of $5,833, or 932 shares per month for one year. During 2005, 7,534 shares vested and the Company recognized a related expense of $40,833. During the nine months ended September 30, 2006, 4,666 shares vested for an expense of $29,166.

Note 12 – FAIR VALUE OF FINANCIAL INSTRUMENTS

     The estimated fair value of the Company’s financial instruments is as follows at:

		September 30,								September 30,								December 31,
		2006								2005								2005
		Carrying				Fair				Carrying				Fair				Carrying				Fair
		Amount				Value				Amount				Value				Amount				Value
Cash and cash equivalents		$	1,242,306			$	1,242,306			$	4,191,755			$	4,191,755			$	4,354,081			$	4,354,081
Marketable securities		$	8,042,189			$	8,042,189			$	7,580,531			$	7,580,531			$	7,478,697			$	7,478,697
Notes payable		$	7,315,805			$	7,275,702			$	3,454,594			$	3,437,469			$	3,435,803			$	3,416,969