SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended August 30, 1997 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission File Number: 0-19194 RAG SHOPS, INC. (Exact name of registrant as specified in its charter) DELAWARE 51-0333503 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 111 WAGARAW ROAD HAWTHORNE, NEW JERSEY 07506 (Address of principal executive (Zip Code) offices) Registrant's telephone number including area code: (973) 423-1303 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.01 PAR VALUE (Title of Class) 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, 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. Yes x No As of October 20, 1997, there were outstanding 4,514,400 shares of Common Stock. Based on the price at which such stock was sold on that date, the approximate aggregate market value of such shares held by non-affiliates was $6,531,544. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's 1997 Definitive Proxy Statement, which statement will be filed not later than 120 days after the end of the fiscal year covered by this Report, are incorporated by reference in Part III hereof. Certain exhibits are incorporated by reference to the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto, as listed in response to Item 14(a)(3). [The remainder of this page is intentionally blank.] PART I ITEM 1. BUSINESS. General Rag Shops, Inc., a Delaware corporation formed in April 1991, is the successor by merger to a New Jersey corporation having the same name which was incorporated in September 1984, as a holding company for numerous subsidiaries that have operated retail stores since 1963. As of August 30, 1997, Rag Shops, Inc. operates 66 specialty retail stores which sell competitively priced fabric and craft merchandise. The Company caters to value conscious consumers who sew and create decorative accessories. The Company believes that its wide selection of currently popular merchandise, value- pricing policy and commitments to both customer service and advertising are principal factors contributing to its profitability. The Company's stores are destination-oriented and also attract shoppers from other stores located in the same shopping center. As of August 30, 1997, the Company operated 33 retail stores in New Jersey, 19 in Florida, seven in Pennsylvania, six in New York and one in Connecticut. The Company anticipates opening two to four stores, relocating one store and closing three stores during the remainder of its fiscal year ending August 29, 1998. The Company's expansion strategy is to grow by expanding within areas from which it presently attracts customers and into contiguous market areas, enabling the Company to capitalize on pre-existing advertising and name recognition. The following table sets forth information with respect to store openings and closings since fiscal 1993: Fiscal Years 1997 1996 1995 1994 1993 Stores open at beginning of period 67 69 68 61 54 Stores opened during period 4 1 2 8 10 Stores closed during period 5 3 1 1 3 Stores open at end of period 66 67 69 68 61 Products The Company's stores offer a diverse and extensive assortment of value-priced crafts, fabrics and related items to creative craft and sewing consumers. For fiscal years 1995, 1996 and 1997, sales of crafts accounted for approximately 66.2%, 65.3% and 67.3% respectively, of the Company's net sales, and sales of fabrics accounted for the remainder. Each of the Company's stores offers fabric, craft and related products. Fabric items available at the Company's stores include apparel and home decorative fabrics, trimmings, patterns and sewing notions. Craft items include silk flowers, wicker, picture frames, wood products, stitchery, yarn, wearable art, art supplies and craft supplies. As of August 30, 1997, fifty-seven stores offer custom picture framing. The Company also sells a wide variety of seasonal merchandise with special emphasis on the Easter, Back-to- School, Halloween and Christmas seasons. Through their purchase of craft, fabric and other items, used either individually or in combination, the Company's customers can hand make a wide variety of finished products for personal use, gifts, home beautification and seasonal decoration. For example, fabrics can be made into career, leisure, children's, bridal and special occasion fashions, draperies and upholstery for home decoration and hand made quilts and, from the Company's selection of craft items, customers can create needle point and stitchery, personalized hand painted apparel, floral arrangements and dolls. Merchandising and Advertising The Company's marketing and merchandising strategy emphasizes the sale of multiple products to be used by the customer to create a single project. To assist customers in making their own selections and to encourage their purchase of several products, the Company's stores display finished models that incorporate a variety of merchandise in close proximity to where the components are sold. The models are created by employees at the stores conforming to Company guidelines. Craft or sewing classes are offered every week at a select number of each of the Company's stores to further promote both specific products and store business. During each class, participants complete a project using materials purchased from the store at which the class is offered. Merchandise instructional demonstrations are held periodically at charitable organizations, conventions and schools as an effective method of attracting customers and generating the purchase of fabrics, crafts and related merchandise necessary for the customer to create the featured apparel. Merchandise at the Company's stores is displayed on conveniently arranged fabric tables and fixtures to facilitate customer access. The general layout of merchandise, adjusted seasonally and as otherwise necessary to adapt to marketing conditions, is planned by the Company's management to give prominence to the types of merchandise currently in demand. Approximately five percent of the Company's sales is expended for a 52 week per year advertising program. In September 1996 the Company commenced utilizing free standing newspaper inserts, alternating with newspaper print advertisements. These newspaper inserts are also displayed at the front of each store and describe a calendar of promotions emphasizing special sale items, seasonal products and other currently popular merchandise. Previously the Company utilized direct mail, newspaper print, weekly in-store promotions and television in the New Jersey metropolitan area and in Florida. The free standing newspaper inserts are received by approximately 3 million people as compared to the direct mail previously utilized that was received by approximately 1 million people. For the Back-to-School season and holiday seasons of Easter, Halloween and Christmas, the Company utilizes a fully developed merchandising program including special inventory, layout, instructional ideas and promotions with highly focused displays. During these peak seasons approximately 25% of store selling space is devoted to seasonal merchandise. Seasonality The Company's business is seasonal, which the Company believes is typical of the retail fabric and craft industry. The Company's highest sales and earnings levels historically occur between September and December. The Company has generally operated at a loss during its fourth fiscal quarter, the June through August summer period. The Company's results of operations depend significantly upon the sales generated from September through December and any material decrease in sales for such period could have a material adverse effect upon the Company's profitability. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Seasonality." Store Operations The Company's store operations are divided into six geographic districts, each managed by a district manager. Stores typically are staffed with a manager, an assistant manager, one department head each for fabrics and crafts, sales personnel, cashiers and stock clerks. District managers supervise store management, monitor the Company's stores to ensure compliance with procedures, policies and budgets, determine whether adequate levels of merchandise are available at the stores and reallocate merchandise among stores as dictated by selling trends at individual stores. Store managers are responsible for operation of individual stores, including recruiting and hiring store personnel. Store managers place orders to replenish inventory from the Company's 85,000 square foot distribution center in Paterson, New Jersey, and may also directly order certain core merchandise designated by management from the Company's suppliers. Orders for merchandise stocked in the distribution center are placed by the store manager on a regular basis through a computer in the store. Deliveries from the distribution center are made by Company-owned vehicles or by independent trucking companies. Stores are generally open from 10:00 A.M. to 9:00 P.M. Monday through Saturday and 11:00 A.M. to 6:00 P.M. on Sunday, with extended hours during the Christmas season. All stores are operating with point-of-sale cash register systems as of July 1997. Approximately 73% of receipts at the Company's stores are for cash or check, with the balance paid for with MasterCard, Visa, Discover or American Express. The average sale is approximately $12.00. Expansion Strategy While management does not believe there are significant geographic constraints on the locations of future stores, the Company's strategy is to grow by expanding within areas from which it presently attracts customers and into contiguous market areas, enabling the Company to capitalize on pre-existing advertising and name recognition. When deciding whether to open a new store, the principal factors the Company typically evaluates are the amount of consumer traffic generated by the market area, the demographic composition of the customer base in the market area, store position in the shopping center, rent structure, available media, advertising expense, and other costs associated with opening the store. Historically, stores tend to become profitable after six to twenty-four months. Sources of Supply The Company purchases its merchandise from more than 300 suppliers. The Company's merchandise is primarily purchased from domestic suppliers (including distributors that import goods from the Far East) and the balance is acquired directly from manufacturers in the Far East, including Hong Kong, Taiwan, Korea, China and the Philippines. All of the merchandise purchased directly from foreign manufacturers, consisting primarily of silk flowers, seasonal merchandise and staple craft products, is sold under the Company's private label. As is customary in the industry, the Company does not have any long-term or exclusive contracts with any suppliers. The Company believes that alternate sources of merchandise are readily available at comparable prices. Consistent with industry practice, merchandise from manufacturers in the Far East is ordered four to six months in advance to assure delivery prior to the selling season for the merchandise. Letters of credit are issued to the foreign manufacturers with specific terms regarding the merchandise ordered, inspection prior to shipment and time and place of delivery. The Company assumes the risk of loss on a F.O.B. basis when goods are delivered to a shipper and is insured against casualty losses arising during shipping. Competition The retail craft and fabric industry (the "Industry") is highly competitive. The Company competes with other national, regional and independent specialty craft and/or fabric retailers and mass merchandisers, some of which have greater financial and other resources than the Company. The Company believes it competes on the basis of merchandise selection, customer service, price and advertising. Competitors include A.C. Moore, Fabri-Centers of America, Inc., and Michaels Stores, Inc. Employees As of August 30, 1997, the Company has approximately 1,080 employees, consisting of approximately 320 full time and 760 part time employees. Full time personnel consist of approximately 190 salaried and 130 hourly employees. All part time personnel are hourly employees. During seasonal peak periods, the Company hires temporary personnel. Approximately 35 employees in the Company's distribution center are covered by a collective bargaining agreement with Local 161 of the Union Of Needletrades, Industrial And Textile Employees, AFL-CIO. This agreement expires in March 1999. The Company considers its relationships with its employees to be good. Trademarks The Company's trademark "THE RAG SHOP" was registered in the United States Patent Office on September 9, 1969 and thereafter renewed. This registration is renewable indefinitely so long as the mark is used by the Company. ITEM 2. PROPERTIES. The Company's office facilities and its Hawthorne, New Jersey store occupy approximately 15,900 and 17,600 square feet, respectively, in the same strip shopping center in Hawthorne, New Jersey. The store and offices are leased from Momar Realty L.L.C., the two members of which are Stanley Berenzweig, Chairman of the Board and Doris Berenzweig, Secretary. The Company's distribution center and all of its other stores are leased from non-affiliates of the Company. The Company's 85,000 square foot distribution center is located in Paterson, New Jersey. The Company believes that its distribution center is adequate for its needs through the expiration of the current term of the lease in July 2000. The Company has one option to renew the lease for a period of two years. The Company also expects to lease approximately 30,000 to 50,000 square feet of warehouse space for approximately eight months each year to accommodate seasonal merchandise. The Company's stores, all of which are located in leased facilities, range in size from approximately 5,200 square feet to 17,600 square feet. The average size of the Company's stores is approximately 9,400 square feet with approximately 90% of the area of each store representing selling space. The Company seeks to open new stores in the range of approximately 12,000 to 15,000 square feet. However, the Company often maintains options to expand store size and will exercise those options or otherwise enlarge particular stores as circumstances warrant. The following table sets forth the number of store leases due to expire, including options to renew, during the year indicated. LEASE EXPIRATIONS Year Number Year Number 2000 1 2013 5 2001 3 2014 3 2003 2 2015 1 2004 2 2016 3 2005 2 2017 9 2006 2 2018 5 2008 4 2019 4 2009 3 2020 2 2010 2 2021 2 2011 4 2023 1 2012 3 2026 1 2027 2 Sixty-three of the above stores are located in strip shopping centers, and the remaining three are free-standing buildings. The stores generally are located in close proximity to population centers and other retail operations and are usually on a major highway or thoroughfare, making them easily accessible by automobile. All of the stores provide free parking. The leases for the Company's stores are generally for a term of five years, usually with four options to renew for five years each. Under most leases, the Company is required to pay, in addition to fixed minimum rental payments, additional rent based on charges for real estate taxes, common area maintenance fees, utility charges and insurance premiums. ITEM 3. LEGAL PROCEEDINGS. The Company is not a party to, nor is any of its property the subject of, any material pending legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Company did not submit any matters to vote of its stockholders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year ended August 30, 1997. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is traded on the NASDAQ National Market System ("NASDAQ/NMS") under the symbol "RAGS." The following table sets forth, for the periods indicated, the range of high and low sale prices of the Common Stock as reported by NASDAQ from September 3, 1995, through August 30, 1997. These prices reflect interdealer prices and do not include retail mark- ups, mark-downs or commissions, and do not necessarily represent actual transactions. High Low Fiscal Quarter Ended November 30, 1996 $ 2.50 $1.938 March 1, 1997 4.313 2.00 May 31, 1997 3.75 2.688 August 30 3.688 2.50 Fiscal Quarter Ended December 2, 1995 $ 3.25 $1.875 March 2, 1996 2.625 1.875 June 1, 1996 2.50 2.00 August 31, 1996 2.50 2.00 On October 20, 1997, the closing price of the Common Stock was $3.15625. The approximate number of stockholders of record of the Common Stock at October 20, 1997 was 270. The number of beneficial owners whose shares are held by banks, brokers and other nominees exceeds 1,000. The Company has not paid any dividends. The Company presently intends to retain all earnings for the operation and expansion of its business and does not anticipate paying cash dividends on its Common Stock in the foreseeable future. Any future determination as to the payment of dividends on the Common Stock will depend upon future earnings, results of operations, capital requirements, the financial condition of the Company and any other factors the Board of Directors of the Company may consider. In addition, pursuant to the Company's bank line of credit, the Company is prohibited from declaring dividends in any year in excess of its earnings for such year or which would otherwise result in a violation of the Company's covenant to maintain a tangible net worth (as defined in the line of credit commitment letter) of $9,000,000. ITEM 6. SELECTED FINANCIAL DATA. Year Ended(1) August 30, August 31, September 2, September 3, August 28, 1997 1996 1995 1994 1993 (in thousands, except Common Stock Data and Statistics) OPERATIONS Net sales $ 86,528 $ 83,767 $ 86,089 $ 89,529 $ 84,151 Gross profit 31,044 30,440 31,592 33,886 34,293 Store exp & general and administrative expenses 30,578 29,500 30,566 32,504 30,953 Interest expense, net 115 161 134 266 46 Income before inc taxes 351 779 893 1,117 3,294 Income before cumulative effect of change in accounting principle 207 520 542 692 2,011 Net income $ 207 $ 520 $ 542 $ 767 $ 2,011 COMMON STOCK DATA Net income per share before cumulative effect of change in acctg principle $ .05 $ .12 $ .12 $ .15 $ .44 Net income per share .05 .12 .12 .17 .44 Dividends per share - - - - - Stockholders' equity per share $ 4.61 $ 4.56 $ 4.45 $ 4.33 $ 4.16 Weighted average out- standing 4,538,971 4,515,527 4,526,108 4,515,102 4,571,305 FINANCIAL POSITION Working capital $ 16,256 $ 16,985 $ 15,161 $ 13,851 $ 13,308 Total assets 32,264 33,555 34,821 36,079 32,136 Short-term 3,119 1,762 4,735 6,555 2,796 Long-term debt 554 1,231 - - - Stockholders' equity $ 20,800 $ 20,593 $ 20,073 $ 19,531 $ 18,764 Year Ended(1) August 30, August 31, September 2, September 3, August 28, 1997 1996 1995 1994 1993 (in thousands, except Common Stock Data and Statistics) STATISTICS Net sales increase (decrease) 3.3% (2.7%) (3.8%) 6.4% 14.4% Comparable store net sales increases(decreases) (1)(3) 3.8% (4.9%) (7.3%) (4.1%) (.5%) Return on net sales, after income taxes .2% .6% .6% .9% 2.4% Return on average stockholders' equity 1.0% 2.6% 2.7% 4.0% 11.3% Average net sales per gross square ft(2) $ 139 $ 135 $ 141 $ 154 $ 166 Average net sales per store (000's)(2) $ 1,296 $ 1,214 $ 1,265 $ 1,362 $ 1,447 Stores open at end of period 66 67 69 68 61 (1) Data for the fiscal years ended August 28, 1993, September 3, 1994, September 2, 1995, August 31, 1996 and August 30, 1997 include the results of operations for 52 weeks, 53 weeks, 52 weeks, 52 weeks and 52 weeks, respectively. (2) For purposes of calculating these amounts, the number of stores and the amount of gross square footage have been adjusted to reflect the number of months during the period that new stores were open. These amounts have not been adjusted to reflect the seasonal nature of the Company's net sales or the resulting impact of opening stores in different periods during the year. See "Management's Discussion and Analysis of Financial Information and Results of Operations--Seasonality." (3) Comparable store sales increases for a fiscal year include stores commencing with their thirteenth consecutive entire fiscal month. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Results of Operations The following table sets forth as a percentage of net sales, certain items appearing in the Company's Consolidated Income Statements for the indicated year Year Ended 1997 1996 1995 Net sales 100.0% 100.0% 100.0% Cost of merchandise sold and occupancy costs 64.1 63.7 63.3 Gross profit 35.9 36.3 36.7 Store expenses 23.9 23.8 23.9 General and administrative expenses 11.5 11.4 11.6 Income from operations 0.5 1.1 1.2 Net income .2% .6% .6% The Company's net sales increased in 1997 by $2,761,000 or 3.3% due to increases in comparable store sales of $3,038,000 or 3.8% in addition to new store sales of $3,417,000 net of the impact of closed store sales. Management believes that the marketing plan launched in September 1996 and the mild weather conditions in the northeast region during the fiscal second quarter compared to the comparable prior periods contributed significantly to the positive comparable store sales results. The Company's net sales decreased in 1996 by $2,323,000 or 2.7% due to decreases in comparable store sales of $4,169,000 or 4.9% partially offset by new store sales of $2,732,000. Management believes the decreases in comparable store sales in 1996 were primarily due to inclement weather conditions in the northeast region during the winter compared to the comparable prior period and the weak retail environment which existed throughout the spring and summer selling seasons in our industry segment. Gross profit percentage decreased by .4% in 1997 as compared to 1996 as a result of an increase in the annual shrinkage of inventory of .7% partially offset by a decrease in markdowns of .4% due to improved control of promotions during the Christmas selling season. Gross profit percentage decreased by .4% in 1996 as compared to 1995 as a result of a 1.2% increase in markdowns, which was primarily attributed to increased competitive promotional sales activity during the Christmas selling season and secondarily to a .7% increase in occupancy costs. These amounts were partially offset by the Company's ability to obtain a .7% increase on the initial markup of inventory purchases by increasing the mix of direct imports, which are more profitable than domestic purchases, and improve the annual shrinkage results by .8%. Store expenses increased by $754,000 or 3.8% in 1997 as compared to 1996. The dollar increase was primarily due to an increase in (i) payroll and payroll related expenses, (ii) depreciation expense due to the installation of the Company's point-of-sale cash register software, data collection and computer systems ("point-of-sale systems") and (iii) advertising in connection with the new marketing plan. As a percentage of net sales, store expenses in 1997 remained relatively constant compared to 1996. Store expenses decreased by $675,000 or 3.3% in 1996 as compared to 1995. The decrease was primarily the result of an expanded vendor cooperative advertising program and secondarily due to a reduction in payroll and payroll related expenses. As a percentage of net sales, store expenses in 1996 remained relatively constant compared to 1995. General and administrative expenses increased by $324,000 or 3.4% in 1997 as compared to 1996. The increase was primarily due to an increase in payroll and payroll related expenses. As a percentage of net sales, general and administrative expenses in 1997 remained relatively constant compared to 1996. General and administrative expenses decreased by $391,000 or 3.9% in 1996 as compared to 1995. As a percentage of net sales, general and administrative expenses decreased by .2% notwithstanding the decrease in net sales and comparable store sales. The decrease in general and administrative expenses and as a percentage of net sales was primarily due to a reduction in payroll and related expenses and secondarily a result of a reduction in professional fees. Interest expense-net decreased in 1997 as compared to 1996 as a result of lower borrowings on the Company's line of credit. This decrease was net of additional interest on the Company's term loan to finance its point-of-sale systems. See "Liquidity and Capital Resources." Interest expense increased in 1996 as compared to 1995 as a result of the Company's term loan discussed above. The effective tax rate for 1997 was 41.0% as compared to 33.2% in 1996. The increase is primarily due to a $15,000 tax settlement paid in 1997 for the tax years 1993 through 1995 based upon the results of an Internal Revenue Service audit. The effective tax rate for 1996 was 33.2% as compared to 39.3% in 1995. The decrease is attributed to Corporate state tax planning that resulted in a lower effective state and local income tax rate. Net income decreased by $313,000 for 1997 as compared to 1996 due to the increase in operating expenses which was partially offset by the increase in sales and the related increase in gross profit. Net income for 1996 remained relatively constant when compared to 1995. Seasonality The Company's business is seasonal, which the Company believes is typical of the retail fabric and craft industry. The Company's highest sales and earnings levels historically occur between September and December. This period includes the Back-to-School, Halloween and Christmas seasons. The Company has generally operated at a loss during its fourth quarter, the June through August summer period. See "Business- - -Seasonality." Year to year comparisons of quarterly results and comparable store sales can be affected by a variety of factors, including the timing and duration of holiday selling seasons and the timing of new store openings and promotional markdowns. Liquidity and Capital Resources The Company's primary needs for liquidity are to maintain inventory for the Company's existing stores and to fund the costs of opening new stores, including capital improvements, initial inventory and pre-opening expenses. In 1997 and 1996, the Company relied on short-term borrowings, internally generated funds and credit made available by suppliers to finance inventories and new store openings. The Company's working capital has decreased $729,000 in 1997 as compared to 1996 primarily as a result of the reduction in its merchandise inventories. The Company maintains a $10 million credit facility with a bank. The credit facility is renewable annually on or before each December 31 and consists of a discretionary $8,000,000 unsecured line of credit for direct borrowings and the issuance and refinance of letters of credit and a $2,000,000 three (3) year term loan maturing May 1, 1999. Borrowings under the line of credit bear interest at the bank's prime rate (8.50% at August 30, 1997) and under the term loan are fixed at eight percent (8%). The credit facility requires the Company to maintain a compensating balance of $400,000 in addition to certain financial covenants which require a minimum defined working capital and tangible net worth, a maximum ratio of debt to tangible net worth and set limits on the payment of dividends. As of August 30, 1997, the Company was in compliance with such covenants. Historically, the amount borrowed has varied based on the Company's seasonal requirements, generally reaching a maximum amount outstanding during the fourth quarter of each fiscal year. The maximum amount borrowed under the line was $2,755,000, $4,935,000 and $6,930,000 in 1997, 1996 and 1995, respectively. As of August 30, 1997 and August 31, 1996, $2,435,000 and $1,130,000, respectively, was outstanding under the line of credit for direct borrowings and $1,227,000 and $1,852,000, respectively, was outstanding under the term loan with $678,000 and $549,000 maturing in 1998 and 1999, respectively. The Company intends to maintain the availability of the line of credit for working capital requirements and in order to be able to take advantage of future opportunities and to continue to utilize the term loan to finance its new point-of-sale systems. The Company completed installation of its point- of-sale systems in all stores as of July 1997. In addition, the Company is continuing with the development of its automated store ordering systems and anticipates commencing installation in January 1998. The Company purchases merchandise directly from manufacturers in the Far East. Generally, these purchases are supported by letters of credit payable in United States dollars. The results of operations of the Company have not been significantly affected by foreign currency fluctuation. At August 30, 1997, the Company had outstanding letters of credit in the approximate amount of $146,600. During 1997, 1996 and 1995, the Company had net cash provided by operating activities of $1,135,000, $2,659,000 and $1,982,000, respectively, and used $1,877,000, $1,001,000 and $432,000, respectively, for purchases of property and equipment. Cash provided by operating activities decreased in 1997 primarily as a result of a reduction in accounts payable due to the timing of merchandise receipts at year end. The Company expects to open two to four stores, relocate one store and close three existing stores during 1998. Costs associated with opening of new stores, including capital expenditures, inventory and pre-opening expenses have approximated $350,000 per store. These costs will be financed primarily from cash provided by operating activities, credit made available by suppliers to finance inventories and, if necessary, from the Company's bank line of credit. However, the Company will redeploy assets of stores being closed to the new stores as opportunities evolve in order to curtail the costs of opening stores. Forward-Looking Statements Certain statements contained in this report that are not historical facts are forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statement. These risks and uncertainties include, but are not limited to, changes in customer demand, changes in trends in the fabric and craft industry, changes in competitive pricing for products, the impact of competitor store openings and closings, the availability of merchandise, general economic conditions, lease negotiations and other risk factors. New Accounting Standards In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS No. 128), which establishes new standards for computing and presenting net income per share and replaces the standards previously found in Accounting Principles Board Opinion No. 15, "Earnings Per Share." The Company will begin reporting net income per share according to this new standard in its 1998 annual report on Form 10-K. The Company does not expect the implementation of SFAS No. 128 to have a material effect on the Company's computation of earnings per share. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130) and No. 131 "Disclosure about Segments of an Enterprise and Related Information" (SFAS No. 131). SFAS No. 130 establishes standards for reporting the display of comprehensive income and its components in a full set of general-purpose financial statements. This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Both SFAS No. 130 and SFAS No. 131 are effective for fiscal periods beginning after December 15, 1997. The Company has not yet determined the impact, if any, of adopting these standards. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See Item 14(a)1 in Part IV. ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required for this item is incorporated by reference to the Company's 1997 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 30, 1997. ITEM 11. EXECUTIVE COMPENSATION. The information required for this item is incorporated by reference to the Company's 1997 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 30, 1997. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required for this item is incorporated by reference to the Company's 1997 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 30, 1997. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required for this item is incorporated by reference to the Company's 1997 Definitive Proxy Statement which the Company will file with the Securities and Exchange Commission no later than 120 days subsequent to August 30, 1997. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Documents filed as part of this report. 1. Financial Statements Page Independent Auditors' Report F-1 Consolidated Balance Sheets as of August 30, 1997 and August 31, 1996 F-2 Consolidated Statements of Income for the years ended August 30, 1997, August 31, 1996 and September 2, 1995 F-3 Consolidated Statements of Stockholders' Equity for the years ended August 30, 1997, August 31, 1996 and September 2, 1995 F-4 Consolidated Statements of Cash Flows for the years ended August 30, 1997, August 31, 1996 and September 2, 1995 F-5 Notes to Consolidated Financial Statements F-7 2. Financial Statement Schedules None 3. Exhibits 3.1* Certificate of Incorporation of the Company 3.2* By-Laws of the Company 10.1* Promissory Note (Revolving) with Valley National Bank 10.2* 1991 Stock Option Plan 10.3* Lease between Momar Realty Co. and the Company, dated as of March 1, 1991 21.1 List of subsidiaries of the Company 23.1 Consent of Deloitte & Touche LLP 24.1 Power of Attorney to sign Form 10-K (set forth on page 20) 27 Financial Data Schedule (Filed electronically with SEC only) ________________________________ *Incorporated by reference to the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto. (b) The Company did not file a Current Report on Form 8-K during the last quarter of the period covered by this Report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto, duly authorized, in the City of Hawthorne, New Jersey, on November 12, 1997. RAG SHOPS, INC. By: /s/ Stanley Berenzweig STANLEY BERENZWEIG, Chairman POWER OF ATTORNEY Each of the undersigned hereby appoints Stanley Berenzweig and Steven Barnett as his or her attorneys-in-fact to sign his or her name, in any and all capacities, to any amendments to this Form 10-K and any other documents filed in connection therewith to be filed with the Securities and Exchange Commission. Each of such attorneys has the power to act with or without the others. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title(s) Date /s/ Michael Aaronson Director November 12, 1997 Michael Aaronson /s/ Steven Barnett Principal Financial November 12, 1997 Steven Barnett Officer, Principal Accounting Officer and Director /s/ Evan Berenzweig Director November 12, 1997 Evan Berenzweig /s/ Stanley Berenzweig Principal Executive November 12, 1997 Stanley Berenzweig Officer and Director /s/ Fred J. Damiano Director November 12, 1997 Fred J. Damiano /s/ Judith Lombardo Director November 12, 1997 Judith Lombardo /s/ Alan C. Mintz Director November 12, 1997 Alan C. Mintz RAG SHOPS, INC. Index to Consolidated Financial Statements INDEX TO EXHIBITS Exhibit Sequentially Number Description of Exhibits Numbered Pages 3.1 Certificate of Incorporation of the Company * 3.2 By-Laws of the Company * 10.1 Promissory Note (Revolving) with Valley National Bank * 10.2 1991 Stock Option Plan * 10.3 Lease between Momar Realty Co. and the Company, dated as of March 1, 1991 * 21.1 List of subsidiaries of the Company 23.1 Consent of Deloitte & Touche LLP 24.1 Power of Attorney to sign Form 10-K (set forth on page 20) 27 Financial Data Schedule (Filed electronically with SEC only) ________________________________ * Incorporated by reference to the Company's Registration Statement on Form S-1 and Amendment No. 1 thereto. RAG SHOPS, INC. AND SUBSIDIARIES Consolidated Financial Statements and Independent Auditors' Report for the Three Years Ended August 30, 1997 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders Rag Shops, Inc. Hawthorne, New Jersey We have audited the accompanying consolidated balance sheets of Rag Shops, Inc. and its subsidiaries as of August 30, 1997 and August 31, 1996, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended August 30, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Rag Shops, Inc. and subsidiaries as of August 30, 1997 and August 31, 1996, and the results of their operations and their cash flows for each of the three years in the period ended August 30, 1997, in conformity with generally accepted accounting principles. Deloitte & Touche LLP Parsippany, New Jersey October 24, 1997 F-1 RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS August 30, August 31, ASSETS 1997 1996 CURRENT ASSETS: Cash $ 763,668 $ 820,985 Merchandise inventories 25,123,037 26,280,442 Prepaid expenses 298,823 345,449 Other current assets 242,297 473,979 Deferred taxes 697,146 727,746 Total current assets 27,124,971 28,648,601 PROPERTY AND EQUIPMENT, NET 4,885,520 4,462,121 OTHER ASSETS 253,198 444,539 $32,263,689 $33,555,261 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Note payable - bank $ 2,435,000 $ 1,130,000 Accounts payable - trade 5,080,546 7,604,083 Accrued expenses and other current liabilities 1,857,216 1,714,346 Accrued salaries and wages 812,028 583,085 Current portion of long-term debt 683,980 631,969 Total current liabilities 10,868,770 11,663,483 DEFERRED TAXES 40,361 68,061 LONG-TERM DEBT 554,298 1,230,880 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value 2,000,000 shares authorized; no shares issued or outstanding - - Common stock, $.01 par value, 13,000,000 shares authorized; 4,514,400 shares issued and outstanding at August 30, 1997 and August 31, 1996 45,144 45,144 Additional paid-in capital 6,039,162 6,039,162 Retained earnings 14,715,954 14,508,531 Total stockholders' equity 20,800,260 20,592,837 $32,263,689 $33,555,261 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Year Ended August 30, August 31, September 2, 1997 1996 1995 NET SALES $86,527,566 $83,766,651 $86,089,364 COST OF MERCHANDISE SOLD AND OCCUPANCY COSTS 55,483,180 53,326,702 54,497,390 Gross profit 31,044,386 30,439,949 31,591,974 OPERATING EXPENSES: Store expenses 20,692,692 19,938,761 20,614,048 General and administrative expenses 9,885,242 9,561,294 9,951,815 Total operating expenses 30,577,934 29,500,055 30,565,863 INCOME FROM OPERATIONS 466,452 939,894 1,026,111 INTEREST EXPENSE, Net 115,129 160,887 133,602 INCOME BEFORE PROVISION FOR INCOME TAXES 351,323 779,007 892,509 PROVISION FOR INCOME TAXES 143,900 258,700 350,600 NET INCOME $ 207,423 $ 520,307 $ 541,909 PER SHARE DATA: NET INCOME PER SHARE $.05 $.12 $.12 WEIGHTED AVERAGE SHARES OUTSTANDING 4,538,971 4,515,527 4,526,108 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Additional Common Stock Paid-In Retained Shares Dollars Capital Earnings Total BALANCE, SEPTEMBER 3, 1994 4,514,400 $45,144 $6,039,162 $13,446,315 $19,530,621 Net income - - - 541,909 541,909 BALANCE, SEPTEMBER 2, 1995 4,514,400 45,144 6,039,162 13,988,224 20,072,530 Net income - - - 520,307 520,307 BALANCE, AUGUST 31, 1996 4,514,400 45,144 6,039,162 14,508,531 20,592,837 Net income - - - 207,423 207,423 BALANCE, AUGUST 30, 1997 4,514,400 $45,144 $6,039,162 $14,715,954 $20,800,260 See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended August 30, August 31, September 2, 1997 1996 1995 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 207,423 $ 520,307 $ 541,909 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,406,285 1,273,770 1,175,746 Deferred taxes 8,000 (132,900) (113,600) Loss on disposition of property and equipment 59,738 15,613 47,397 Changes in assets and liabilities: (Increase) decrease in: Merchandise inventories 1,157,405 1,278,377 302,872 Prepaid expenses 46,626 195,438 6,946 Other current assets 231,682 (381,948) (37,457) Other assets 169,668 (129,917) 15,659 Increase (decrease) in: Accounts payable - trade (2,523,537) 156,121 144,322 Accrued expenses and other current liabilities 142,870 (66,206) 170,632 Accrued salaries and wages 228,943 (69,211) (272,904) Net cash provided by operating activities 1,135,103 2,659,444 1,981,522 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of property and equipment 4,331 3,895 2,350 Payments for purchases of property and equipment (1,877,180) (1,000,511) (432,155) Net cash used in investing activities (1,872,849) (996,616) (429,805) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of note payable - bank 14,520,000 34,415,000 29,101,000 Repayments of note payable - bank (13,215,000)(38,020,000) (30,921,000) Long-term borrowings - 2,000,000 - Repayments of long-term debt (624,571) (148,080) - Net cash provided by (used in) financing activities 680,429 (1,753,080) (1,820,000) NET DECREASE IN CASH (57,317) (90,252) (268,283) CASH, BEGINNING OF YEAR 820,985 911,237 1,179,520 CASH, END OF YEAR $ 763,668 $ 820,985 $ 911,237 (continued) RAG SHOPS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest $ 165,922 $ 232,667 $ 104,004 Income taxes $ 532,087 $ 200,013 $ 463,756 SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Purchase of property and equipment in exchange for debt $ - $ 10,929 $ - See notes to the consolidated financial statements. RAG SHOPS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary Of Significant Accounting Policies Organization and Nature of Business Rag Shops, Inc. (the "Company"), a Delaware corporation formed in April 1991, is the successor by merger to a New Jersey Corporation having the same name which was incorporated in 1984. The Company operates a chain of retail fabric and craft stores through its subsidiaries predominantly located in New Jersey, New York, Pennsylvania and Florida. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. All significant intercompany transactions and balances have been eliminated. Merchandise Inventories Inventories are stated at the lower of cost (first-in, first-out method) or market as determined by the retail inventory method, and consist primarily of fabrics and crafts. Property and Equipment Property and equipment are stated at cost. Depreciation is computed over the estimated useful lives of the assets using straight-line and accelerated methods. Leasehold improvements are amortized by the straight-line method over an estimated useful life or the term of the related lease, whichever is shorter. Effective September 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" (SFAS No. 121). This Statement establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles and goodwill related to those assets to be held and used, and for long-lived assets and certain identifiable intangibles to be held and used by an entity to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.The provisions of SFAS No. 121 did not have any impact on the Company's financial position or results of operations. Pre-opening and Closing Store Expenses All pre-opening costs incurred in connection with the opening of new retail stores are charged to expense on or before the stores opening. Costs associated with closing stores, when material, are charged to expense at the time the decision to close a store is determined. Amortization Lease acquisition costs are being amortized on the straight-line method over the remaining lives of the leases. Net Income Per Share Net income per share is based on the weighted average number of shares outstanding during each period. The dilutive effect of stock options and warrants is included in each of the three fiscal years in the period ended August 30, 1997. Recent Accounting Pronouncements In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS No. 128), which establishes new standards for computing and presenting net income per shareand replaces the standards previously found in Accounting Principles Board Opinion No. 15, "Earnings Per Share." The Company will begin reporting net income per share according to this new standard in its 1998 annual report on Form 10-K. The Company does not expect the implementation of SFAS No. 128 to have a material effect on the Company's computation of earnings per share. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS No. 130) and No. 131 "Disclosure about Segments of an Enterprise and Related Information" (SFAS No. 131). SFAS No. 130 establishes standards for reporting the display of comprehensive income and its components in a full set of general-purpose financial statements. This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately form retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Both SFAS No. 130 and SFAS No. 131 are effective for fiscal periods beginning after December 15, 1997. The Company has not yet determined the impact, if any, of adopting these standards. Use Of Estimates The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the Company's financial statements and accompanying notes to financial statements. Actual results could differ from those estimates. Fair Value Of Financial Instruments Management of the Company believes that the fair value of financial instruments approximates their cost as of August 30, 1997 and August 31, 1996. In management's opinion, the fair value of its fixed-rate term loan approximates book value based on borrowing rates currently available to the Company and amounts outstanding under its line of credit approximate fair value due to their variable rate. Fiscal Year The Company's fiscal year end is the Saturday closest to August 31. The financial statements for the fiscal years ended September 2, 1995, August 31, 1996 and August 30, 1997 were each comprised of 52 weeks. Note 2. Property And Equipment Property and equipment consists of the following: Useful August 30, August 31, Lives 1997 1996 Furniture and fixtures 5-10 years $7,127,202 $6,744,696 Leasehold improvements 10 years 2,579,142 2,340,000 Transportation equipment 3-7 years 461,324 440,940 Data processing equipment 5 years 3,295,785 2,359,911 13,463,453 11,885,547 Less accumulated depreciation and amortization 8,577,933 7,423,426 $ 4,885,520 $4,462,121 Note 3. Note Payable - Bank The Company maintains a $10,000,000 credit facility with a bank. The credit facility is renewable annually on or before each December 31 and consists of a discretionary $8,000,000 unsecured line of credit for direct borrowings and the issuance and refinance of letters of credit and a $2,000,000 three year term loan (see Note 4). The facility requires the Company to maintain a compensating balance of $400,000 in addition to certain financial covenants which require a minimum defined working capital and tangible net worth, a maximum ratio of debt to tangible net worth and set limits on the payment of dividends. As of August 30, 1997, the Company was in compliance with such covenants. Borrowings under the line of credit bear interest payable quarterly at the bank's prime rate (8.50% at August 30, 1997). The borrowings outstanding under the line of credit as of August 30, 1997 and August 31, 1996 were $2,435,000 and $1,130,000, respectively, and the unused line of credit for direct borrowings and the issuance of letters of credit at August 30, 1997 was $5,418,381. Note 4. Long-Term Debt Long-term debt outstanding consists of the following: August 30, August 31, 1997 1996 Term loan $1,227,349 $1,851,920 Other 10,929 10,929 1,238,278 1,862,849 Less current portion 683,980 631,969 $ 554,298 $1,230,880 During the year ended August 31, 1996, the Company borrowed $2,000,000 ("term loan") under the terms of its credit facility with a bank to finance its new point-of-sale cash register software, data collection and computer systems. Interest on the term loan is payable monthly at a fixed interest rate of 8%. The term loan matures May 1, 1999, has monthly payments of $62,673 and is collateralized by equipment having a net book value of $1,630,945 as of August 30, 1997. Aggregate annual maturities of long-term debt are as follows: Fiscal Year Ended 1998 $ 683,980 1999 554,298 $1,238,278 Note 5. Commitments And Contingencies The Company leases its facilities in accordance with operating leases, having initial terms of more than one year, which expire in various years through 2012. Substantially all of the leases contain renewal options. In addition, certain leases require that the Company pay its pro rata share of utilities, taxes, insurance and maintenance. Rent expense for 1997, 1996 and 1995 amounted to $6,140,557, $5,863,758 and $5,606,092, respectively, and includes contingent rentals (computed on a percentage of sales, as defined in the leases) of $28,168, $42,565, and $84,269, respectively. The Company leases certain premises from an entity controlled by the majority stockholders of the Company. For the years ended 1997, 1996 and 1995, rental payments under this agreement amounted to $307,695, $288,897, and $269,435, respectively. Future minimum annual rental commitments under noncancellable operating leases are as follows: Fiscal Year Ended 1998 $6,200,136 1999 4,944,808 2000 4,003,055 2001 2,951,617 2002 1,873,916 Thereafter 4,118,514 $24,092,046 In addition, at August 30, 1997 the Company has outstanding letters of credit for the purchase of merchandise inventories of approximately $146,600. Note 6. Stock Options And Warrants In April 1991, the Company adopted the 1991 Stock Option Plan (the "Plan") covering employees and nonemployee directors. The plan permits options to purchase a total of 450,000 shares of common stock, of which 435,600 shares have been reserved by the Company as of August 30, 1997. Such options may be incentive stock options ("ISO") or nonqualified options. The term of an option will not exceed ten years and an option is exercisable as determined by the Option Committee of the Board of Directors. The exercise price of the shares covered by an ISO may not be less than the fair market value of the shares at the time of grant. The exercise price of the shares covered by a nonqualified option is determined by the Option Committee. The options granted are generally exercisable 20% per year. The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS No. 123). Accordingly, no compensation cost has been recognized for the stock options awarded. Had compensation cost for the Company's stock option plan been recorded based on the fair value at the grant date for awards in 1997 consistent with the provisions of SFAS No. 123, the Company's net income and income per share would have been reduced to the pro forma amounts indicated below: Net income-as reported $207,423 Net income-pro forma $201,139 Net income per share as reported $ .05 Net income per share-proforma $ .04 The weighted-average fair value per share of options granted during the year is $1.39. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1997: dividends yield of 0%, expected volatility of 50%, risk-free interest rate of 4.5% and expected lives of 7.5 years. Information with respect to options granted under the Plan is as follows: Number of Exercise Price Weighted-Average Shares Per Share Exercise Price Outstanding, September 3, 1994 259,800 $6.00-$12.375 $7.213 Granted 70,000 $2.375-$3.188 $2.607 Canceled (105,650) $6.00-$12.375 $7.583 Outstanding, September 2, 1995 224,150 $2.375-$12.375 $5.601 Granted 12,000 $2.125 $2.125 Canceled (21,400) $3.188-$12.375 $6.107 Outstanding, August 31, 1996 214,750 $2.125-$12.375 $5.356 Granted 115,000 $2.34-$3.00 $2.362 Canceled (23,700) $2.125-$12.375 $7.228 Outstanding, August 30, 1997 306,050 $2.125-$12.375 $4.086 Exercisable, September 2, 1995 115,150 $6.00-$12.375 $6.814 Exercisable, August 31, 1996 136,200 $6.00-$12.375 $6.726 Exercisable, August 30, 1997 145,050 $2.375-$12.375 $5.980 The weighted-average remaining contractual life of stock options outstanding at August 30, 1997 is 6.8 years. Note 7. Income Taxes Income tax expense consists of the following: Year Ended August 30, August 31, September 2, 1997 1996 1995 Federal: Current $ 135,900 $ 362,800 $ 314,400 Deferred 8,000 (115,800) (60,400) State: Current - 28,800 149,800 Deferred - (17,100) (53,200) $ 143,900 $ 258,700 $ 350,600 The deferred income tax arises from the following temporary differences: Year Ended August 30, August 31, September 2, 1997 1996 1995 Uniform inventory capitalization $(30,600) $ 53,800 $ 20,000 Depreciation 27,700 64,600 22,100 Straight-line of leases (5,100) 14,500 18,300 Reserves not deductible - - 53,200 $ (8,000) $ 132,900 $ 113,600 The effective tax rate differs from the Federal statutory rate as follows: Year Ended August 30, August 31, September 2, 1997 1996 1995 Statutory tax rate 34.0% 34.0% 34.0% State and local income taxes, net of federal income tax benefit - 1.0 7.1 Other 7.0 (1.8) (1.8) Effective tax rate 41.0% 33.2% 39.3% Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company's state deferred tax asset has been reduced by a valuation allowance based on current evidence indicating that it is not more likely than not that the future benefits of these temporary differences will be realized. The tax effect of significant items comprising the Company's deferred tax assets and liabilities are as follows: Year Ended August 30, August 31, 1997 1996 Current Deferred tax asset: Uniform inventory capitalization $697,146 $727,746 Non-current deferred tax assets: Straight-line of leases 111,673 116,773 Net operating losses for State purposes 404,522 219,210 Valuation allowance (329,822) (144,510) 883,519 919,219 Non-current deferred tax liability: Difference between book and tax depreciation methods 40,361 68,061 Net deferred tax asset $843,158 $851,158 Note 8. Employee Benefit Plan Effective January 1, 1996, the Company adopted a voluntary 401(k) savings plan. All non-union employees of the Company are eligible to participate on or after reaching age 21 and completing one year of eligibility service. The Company did not make any discretionary contributions to the 401(k) plan for the years ended August 30, 1997 and August 31, 1996. Note 9. Quarterly Results (Unaudited) The following is a summary of selected quarterly financial data (thousands of dollars, except per share amounts): Fiscal Quarter Ended Nov. 30, Mar. 1, May 31, Aug. 30, Fiscal 1997 1996 1997 1997 1997 Net sales $26,181 $23,707 $19,629 $17,011 Gross profit 9,791 8,718 7,120 5,415 Net income (loss) 921 218 167 (1,099)(a) Net income (loss) per share .20 .05 .04 (.24)(a) Fiscal Quarter Ended Dec. 2, Mar. 2, Jun. 1, Aug. 31, Fiscal 1996 1995 1996 1996 1996 Net sales $27,782 $21,063 $18,506 $16,416 Gross profit 10,442 7,148 6,756 6,094 Net income(loss) 736 (303) 366 (279)(a) Net income(loss) per share .16 (.07) .08 (.06)(a) (a) Included in the fiscal quarter ended August 30, 1997 and August 30, 1996 was a charge $220,000 or $.05 per share and a credit of $335,000 or $.07 per share, respectively, based on the Company's annual shrinkage results compared to those estimates. Net income per share calculations are based on the weighted average number of shares outstanding during each of the quarters. The sum of the four quarters may not equal the full year computation due to rounding. * * * * * * EXHIBIT 21.1 RAG SHOPS, INC. LIST OF SUBSIDIARY COMPANIES Name State Incorporated RSL, Inc. Delaware Mobile Fabrics, Inc. New Jersey The Rag Shop/Glen Burnie, Inc. Maryland The Rag Shop, Inc. New York Rag Shop/Wayne, Inc. New Jersey Rag Shop/Parsippany, Inc. New Jersey Rag Shop/Edison, Inc. New Jersey The Rag Shop/West Orange, Inc. New Jersey The Rag Shop/Middletown, Inc. New Jersey The Rag Shop/Toms River, Inc. New Jersey The Rag Shop/Hamilton Square, Inc. New Jersey The Rag Shop/Hazlet, Inc. New Jersey The Rag Shop/Howell, Inc. New Jersey The Rag Shop/Ocean, Inc. New Jersey The Rag Shop/Sayreville, Inc. New Jersey The Rag Shop/Bricktown, Inc. New Jersey The Rag Shop/Totowa, Inc. New Jersey The Rag Shop/North Lauderdale, Inc. Florida The Rag Shop/West Palm Beach, Inc. Florida The Rag Shop/Palm Beach Gardens, Inc. Florida The Rag Shop/Lancaster, Inc. Pennsylvania The Rag Shop/Sunrise, Inc. Florida The Rag Shop/Lantana, Inc. Florida The Rag Shop/York, Inc. Pennsylvania The Rag Shop/Selinsgrove, Inc. Pennsylvania The Rag Shop/Pembroke Pines, Inc. Florida The Rag Shop/Jacksonville, Inc. Florida The Rag Shop/Olean, Inc. New York The Rag Shop/Boca Raton, Inc. Florida The Rag Shop/Port Richey, Inc. Florida The Rag Shop/Deptford, Inc. New Jersey The Rag Shop/Deerfield, Inc. Florida The Rag Shop/Jacksonville-San Jose, Inc. Florida The Rag Shop/Rostraver, Inc. Pennsylvania The Rag Shop/Evesham, Inc. New Jersey The Rag Shop/Allentown, Inc. Pennsylvania The Rag Shop/Jensen Beach, Inc. Florida The Rag Shop/Jacksonville-Orange Park, Inc. Florida The Rag Shop/Jacksonville-Regional, Inc. Florida The Rag Shop/Boro Park, Inc. New York The Rag Shop/Secaucus, Inc. New Jersey The Rag Shop/North Bergen, Inc. New Jersey The Rag Shop/Coral Springs, Inc. Florida The Rag Shop/Turnersville, Inc. New Jersey The Rag Shop/Hialeah, Inc. Florida The Rag Shop/Hollywood, Inc. Florida The Rag Shop/Binghamton, Inc. New York (continued) (continued) RAG SHOPS, INC. LIST OF SUBSIDIARY COMPANIES Name State Incorporated The Rag Shop/Lacey, Inc. New Jersey The Rag Shop/West Boca Raton, Inc. Florida The Rag Shop/Ocala, Inc. Florida The Rag Shop/Fishkill, Inc. New York The Rag Shop/Hampden, Inc. Pennsylvania The Rag Shop/East Norriton, Inc. Pennsylvania The Rag Shop/Wall Township, Inc. New Jersey The Rag Shop/Northern Lights, Inc. New York The Rag Shop/Linden, Inc. New Jersey The Rag Shop/Burlington, Inc. New Jersey The Rag Shop/Kingstown, Inc. Rhode Island The Rag Shop/Norwalk, Inc. Connecticut The Rag Shop/East Hollywood, Inc. Florida The Rag Shop/Edgewater, Inc. New Jersey Each of the above does business under the name "The Rag Shop." EXHIBIT 23.1 RAG SHOPS, INC. INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in the Registration Statement of Rag Shops, Inc. on Form S-8 of our report dated October 24, 1997, appearing in this Annual Report on Form 10-K of Rag Shops, Inc. for the year ended August 30, 1997. Deloitte & Touche LLP Parsippany, New Jersey November 12, 1997