**SECURITIES AND EXCHANGE COMMISSION********Washington, D.C. 20549**

 

**FORM 10-KSB**

 

**ANNUALREPORT UNDER SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31,2003**

 

**Commission file number 0-24557**

 

**CARDINALFINANCIAL CORPORATION**

(Name of Small Business Issuer in its Charter)

 

| **Virginia**                                                    |   | **54-1874630**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or Other Jurisdiction  of Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **8270 Greensboro Drive, Suite 500  McLean, Virginia**          |   | **22102**                             |
| (Address of Principal Executive Offices)                        |   | (Zip Code)                            |

 

**(703) 584-3400**(Issuer’s Telephone Number, Including Area Code)

 

Securities registered under Section 12(g) of the ExchangeAct:

 

**Common Stock, par value $1.00 per share7.25% Cumulative Convertible Preferred Stock, Series A, par value $1.00 pershare**

(Title of Class)

 

Check whether the issuer:  (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for past 90 days.

Yes       ý                                           No                                o

 

Check if there is no disclosure of delinquent filers in response to Item405 of Regulation S-B contained in this form, and no disclosure will be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB.        o

 

The issuer’s revenues for the fiscal year ended December 31, 2003 were$28,431,000.

 

The aggregate market value of the voting shares held by non-affiliatescomputed by reference to the price at which the stock was sold, or the averagebid and asked prices of such stock, as of March 12, 2004 was $148,069,120.

 

The number of shares outstanding of Common Stock, as of March 12, 2004 was17,550,211.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

** **

Proxy Statement for 2004 Annual Meeting of Shareholders

 

 

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**TABLE OF CONTENTS**

 

 
|     | **PART  I**                                                                                                      | 3      |
|----------|------------------------------------------------------------------------------------------------------------------|--------|
|     |                                                                                                             |   |
| Item 1.  | Description  of Business                                                                                         | 3      |
|     |                                                                                                             |   |
| Item 2.  | Description of Property                                                                                          | 20     |
|     |                                                                                                             |   |
| Item 3.  | Legal Proceedings                                                                                                | 22     |
|     |                                                                                                             |   |
| Item  4. | Submission  of Matters to a Vote of Security Holders                                                             | 22     |
|     |                                                                                                             |   |
|     | **PART II**                                                                                                      | 23     |
|     |                                                                                                             |   |
| Item  5. | Market  for Common Equity and Related Stockholder Matters                                                        | 23     |
|     |                                                                                                             |   |
| Item  6. | Management’s  Discussion and Analysis of Financial Condition and Results of Operation                       | 24     |
|     |                                                                                                             |   |
| Item  7. | Financial  Statements                                                                                            | 49     |
|     |                                                                                                             |   |
| Item  8. | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                            | 84     |
|     |                                                                                                             |   |
| Item 8A. | Controls and Procedures                                                                                          | 84     |
|     |                                                                                                             |   |
|     | **PART III**                                                                                                     | 85     |
|     |                                                                                                             |   |
| Item 9.  | Directors, Executive Officers, Promoters and  Control Persons; Compliance with Section 16(a) of the Exchange Act | 85     |
|     |                                                                                                             |   |
| Item 10. | Executive Compensation                                                                                           | 85     |
|     |                                                                                                             |   |
| Item 11. | Security Ownership of Certain Beneficial Owners  and Management                                                  | 85     |
|     |                                                                                                             |   |
| Item 12. | Certain Relationships and Related Transactions                                                                   | 85     |
|     |                                                                                                             |   |
| Item 13. | Exhibits and Reports on Form 8-K                                                                                 | 86     |
|     |                                                                                                             |   |
| Item 14. | Principal Accountant Fees and Services                                                                           | 87     |

 

 

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**PARTI.**

 

**Item1.  Description of Business**

 

**Overview**

 

We own Cardinal Bank, N.A., anationally chartered community bank headquartered in Tysons Corner, Virginia.Cardinal Bank has offices in Alexandria, Arlington, Fairfax City, Herndon,Leesburg, McLean, Reston, Sterling, Manassas, Tysons Corner, and Woodbridge,Virginia.  We conduct virtually all ofour business through Cardinal Bank, N.A. and Cardinal Wealth Services, Inc.

 

**History**

 

Cardinal Financial Corporationwas formed in late 1997, principally in response to opportunities resultingfrom the consolidation of several Virginia-based banks with regional bankholding companies.  In our market area,these bank consolidations had been accompanied by the dissolution of localboards of directors and relocation or termination of management and customerservice professionals.

 

We organized Cardinal Bank N.A.as a wholly owned subsidiary that commenced operations on June 8, 1998.  Subsequently, we organized two additionalwholly owned subsidiaries: Cardinal Bank – Manassas/Prince William, N.A.,headquartered in Manassas, Virginia, that commenced operations on July 26,1999; and Cardinal Bank – Dulles, N.A., headquartered in Reston, Virginia, thatcommenced operations on August 2, 1999. In addition to the banks that we organized ourselves, effective as ofSeptember 1, 2000, we acquired The Heritage Bank through a merger with HeritageBancorp, Inc. The Heritage Bank was renamed Cardinal Bank – Potomac as a resultof the merger.  Effective March 1, 2002,we reorganized these four banking subsidiaries into a single bank, CardinalBank, N.A.

 

**Growth Strategy**

 

We believe that the recent andongoing bank consolidation within the greater Washington, D.C. metropolitanarea provides a significant opportunity to build a successful community-focusedbanking franchise.  We intend tocontinue to expand our business through internal growth as well as selectivegeographic expansion while maintaining strong asset quality and achievingsustained profitability.

 

**Expand our footprint through branch expansion.**  We intend to continue to expandour footprint by establishing new branches or acquiring existing branches orother financial institutions in communities that present attractive growthopportunities within Northern Virginia and other markets in the greaterWashington, D.C. metropolitan area.  InSeptember 2003, we opened a second Tysons Corner branch office in the lobby ofour corporate headquarters building.  InOctober 2003, we opened our second Loudoun County branch office in downtownLeesburg, Virginia.  In December 2003,we opened our first eastern Prince William County office in Woodbridge,Virginia.  In February 2004, we opened abranch office in Herndon, Virginia.  Allof these new branch offices are former branch locations of larger financialinstitutions.

 

As a result of the recentconsolidation in our local banking market, we expect to continue to haveopportunities to acquire or lease former branch sites from other financialinstitutions.  As we have done in thepast, we may acquire additional sites prior to planned branch openings when

 

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webelieve the sites are attractive and are available on favorable terms.  At the present time, we have a first rightof refusal that gives us the option to purchase two branch facilities if thefinancial institution now operating in these locations chooses to close or movetheir operations anytime before January 2010. We are also currently in negotiations to purchase or lease additionalbranch sites located in Northern Virginia, although there can be no assurancethat we will be successful in acquiring any of them.  Our current plans contemplate that we will add as many as eightnew branches by the end of 2005. Because the opening of each new branch increases our operating expenses,we intend to stage new branch openings in an effort to take into account theimpact on our results of operations.

 

**Capitalize on the continued bank consolidation in our market.**  Several recently announced orcompleted mergers of larger regional and national banks will result in furtherconsolidation in our target market over the coming months.  We intend to capitalize on the dislocationof banking customers resulting from this continuing consolidation who areseeking more personalized service from a local institution.  We believe this consolidation createsopportunities for us to further expand our branch network to attractive retailsites, as discussed above, as well as to increase our market share of bankdeposits within out target market.  As alocal banking organization, we believe we can compete effectively by providinga high level of personalized service in a retail-oriented branch system.

 

Although we are not at this timeengaged in negotiations with any specific bank acquisition targets, we willcontinue to explore the possibility of further growth through acquisition inVirginia and the metropolitan Washington, D.C. market.

 

**Expand our lending activities.**  We substantially increased ourlegal lending limit to over $12.0 million as a result of the completion of oursecondary offering in December 2003. The increase in our legal lending limit will allow us to further expandour commercial and real estate lending activities.  It will also improve our ability to serve larger residentialhomebuilders and allow us to seek business from larger government contractorsin the greater Washington, D.C. area. Government procurement in the greater Washington region exceeded $35billion in 2002, and we believe there are unique growth opportunities in thissector of our regional economy.  As wegrow, our goal is to significantly increase our loan-to-deposit ratio and shiftthe mix of our earning assets to higher yielding loans.  During significant periods of growth in ourloan portfolio, our earnings could be impacted by additional provisions to ourallowance for loan losses to reflect this growth.

 

**Continue to recruit experienced lenders.**  We have been successful inrecruiting senior lenders with experience in and knowledge of our markets whohave been displaced or have grown dissatisfied as a result of the bankconsolidation in our market.  We intendto continue our efforts to recruit experienced lenders within our market whocan have an immediate impact on generating additional loan volume throughexisting relationships.

 

**Focus onspecialized lending services.**  We have expanded certain existingproduct lines, including government contract receivables lending, SBAguaranteed lending, and retail lending. Our goal is to create a diversified, community-focused bankingfranchise, balanced between retail, commercial and real estate transactions andservices.

 

**Offer additional financial products and services.**  We plan to commencemortgage-banking services through a subsidiary to enhance our participation inthe Washington metropolitan area residential mortgage lending market and createadditional fee income.  We have delayedour entry into the mortgage banking business due to the high price of entrycaused by

 

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unprecedentedlevels of refinancings resulting from record low interest rates.  However, with rates at cyclical lows, webelieve conditions will be favorable within the next 12-18 months to start-upor acquire a mortgage-banking subsidiary and take advantage of the continuedstrong housing market in the Washington metropolitan area.  Our focus will be to build relationshipswith local and national homebuilders in an attempt to reduce reliance on thecyclical refinancing market to remain competitive in this area.  Building relationships with largerhomebuilders will also assist us in our efforts to increase our commercial realestate lending activities.

 

We plan to further develop and expand the investment services we offerthrough our wealth management subsidiary. We believe we have opportunities to cross-sell additional services toour existing customers and that we will be able to attract new customers byoffering a broader array of financial products and services.

 

**MarketArea**

 

Weconsider our targetmarket to be the greater Washington metropolitan area, which we define as theDistrict of Columbia, the Northern Virginia counties of Arlington, Fairfax,Fauquier, Loudoun, Prince William, Spotsylvania and Stafford, the NorthernVirginia cities of Alexandria, Manassas, Fairfax and Falls Church and theMaryland counties of Frederick, Montgomery and Prince George’s.

 

Accordingto 2000 U.S. Census data, the population of the greater Washington metropolitanarea was approximately 4.5 million people. The average of the median household income figures reported in the 2000U.S. Census for each of the 15 jurisdictions comprising the greater Washingtonmetropolitan area was approximately $64,200, compared to a national medianhousehold income of approximately $42,000. Based on estimates released by the Bureau of Labor Statistics of theU.S. Department of Labor for December 2003, the unemployment rate for thegreater Washington metropolitan area was approximately 3.0%, compared to anational unemployment rate of 5.7%. According to 2000 U.S. Census figures, approximately 44% of adults atleast 25 years old in this area have a bachelor’s degree or higher, compared toapproximately 24% nationally.  As ofJune 30, 2003, total deposits in this area were approximately $104 billion.

 

Our headquarters is located approximately seven miles west ofWashington, D.C. in Fairfax County, Virginia. The 2000 U.S. Census data indicates that Fairfax County is the mostpopulous county in Virginia with a population of approximately one millionpeople and a median household income of over $81,000.  Based on estimates released by the Bureau of Statistics of theU.S. Department of Labor for December 2003, the unemployment rate in FairfaxCounty was 1.9%.  The 2000 U.S. Censusdata shows that over 54% of Fairfax County adults at least 25 years old have abachelor’s degree or higher.

 

**Competition**

 

The greaterWashington region is dominated by branches of large regional or national banksheadquartered outside of the region. Our market area is a highly competitive, highly branched bankingmarket.  We compete as a financial intermediarywith other commercial banks, savings and loan associations, credit unions,mortgage banking firms, consumer finance companies, securities brokerage firms,insurance companies, money market mutual funds and other financial institutionsoperating in the Greater Washington region and elsewhere.

 

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Competitionfor deposits and in providing lending products and services to small businessesand professionals in the market area is intense, and pricing is important.  Many of our competitors have substantiallygreater resources and lending limits than we do.  In addition, many competitors offer extensive branch networksthat we currently do not provide. Moreover, larger institutions operating in the greater Washington markethave access to borrowed funds at lower costs than are available to us. However,we have succeeded in competing in this environment due to an emphasis on a highlevel of personalized customer service and community involvement whilemaintaining conservative credit underwriting standards.

 

With over 1,500 bank branches in the greaterWashington region, deposit competition among institutions in the market areaalso is very strong.  However, of the$104 billion in bank deposits in the greater Washington region at June 30,2003, just over 70% were held by banks that are either based outside of thegreater Washington region or are operating wholesale banks drawing depositsnationally (E*TRADE Bank, Capital One Bank and Treasury Bank). In just overfive years, we have grown to the seventh largest financial institution headquarteredin the greater Washington region measured by total deposits.  By providing competitive products and morepersonalized service, and being actively involved in our local communities, wefeel we can continue to increase our share of this banking deposit market.

 

**Customers**

 

We believe that the recent and ongoing bankconsolidation within Northern Virginia and the greater Washington regionprovides a significant opportunity to build a successful, locally-orientedbanking franchise.  We also believe thatmany of the larger financial institutions in our area do not emphasize a highlevel of personalized service to the small and medium-sized commercial,professional or individual retail customer. Our commercial relationship managers focus their marketing efforts onattracting small and medium-sized businesses as well as commercial real estatedevelopers and builders and professionals, such as physicians, accountants andattorneys.

 

Although we expect to continue serving thebusiness and professional market with experienced commercial relationshipmanagers, we have increased our retail marketing efforts through the expansionof our branch network and development of additional retail products andservices. We expanded our deposit market share through aggressive marketing ofour President’s Club relationship product and our Totally Free Checkingproduct. In addition, during the second quarter of 2002, we organized ourretail lending group which specializes in consumer lending products, and in2003 we established a small business lending group and a government contractlending group.

 

**Banking Products and Services**

 

The principal business of the bank is to acceptdeposits from the public and to make loans and other investments.  The principal sources of funds for thebank’s loans and investments are demand, time, savings and other deposits,repayment of loans, and borrowings.  Theprincipal source of income for the bank is interest collected on loans andother investments.  The principalexpenses of the bank are interest paid on savings and other deposits, employeecompensation, office expenses, and other overhead expenses.  The bank does not currently offer trust orfiduciary services.

 

The bank is committed to providing high qualitybanking products and services to its customers, and has made a significantinvestment in its core banking systems, which supports

 

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virtually every banking function.  The system provides the technology thatfully automates the branches, processes bank transactions, mortgages, loans andelectronic banking, conducts database and direct response marketing, providescash management solutions, streamlined reporting and reconciliation support aswell as sales support.

 

With this investment in technology, the bankoffers Internet-based delivery of products for both consumers and commercialcustomers.  Customers can open accounts,apply for loans, check balances, check account history, transfer funds, pay bills,download account transactions into QuickenTM and Microsoft MoneyTM, useinteractive calculators and correspond via e-mail with the bank over theInternet.  The Internet provides aninexpensive way for the bank to expand its geographic borders and branch activitieswhile providing the kind of services one would expect from larger banks.

 

Weoffer a broad array of banking products and services to our customers.  These products and services are set forthbelow.

 

*Lending*

 

Weoffer a full range of short- to long-term commercial, real estate and consumerlending products and services, which are described in further detailbelow.  We have establishedpre-determined target levels as targets for the diversification of our loanportfolio across the various categories of loans.  Commercial loans, real estate-commercial loans, realestate-construction loans, real estate-residential loans, home equity loans,and consumer loans account for approximately 17%, 41%, 13%, 13%, 13% and 3%,respectively of our loan portfolio at December 31, 2003.  We may adjust these levels from time to timeas the credit demands of the community change and as our business evolves.

 

*Commercial Loans.*  We make commercial loans toqualified businesses in our market area. Our commercial lending portfolio consists primarily of commercial andindustrial loans for the financing of accounts receivable, inventory, property,plant and equipment.  Our recentlyestablished government contracting lending group provides secured lending togovernment contract firms and businesses based primarily on receivables fromthe federal government.  We have alsorecently begun offering Small Business Administration (SBA) guaranteed loansand asset-based lending arrangements to certain of our customers.  In 2003, we became certified as a preferredlender by the SBA, which provides us with much more flexibility in approvingloans guaranteed under the SBA’s various loan guaranty programs.

 

Commercialloans generally have a higher degree of risk than residential mortgage loans,but have commensurately higher yields. Residential mortgage loans generally are made on the basis of theborrower’s ability to repay the loan from his or her employment and otherincome and are secured by real estate, the value of which generally is readilyascertainable.  In contrast, commercialloans typically are made on the basis of the borrower’s ability to repay theloan from cash flow from its business and are secured by business assets, suchas commercial real estate, accounts receivable, equipment and inventory.  As a result, the availability of funds forthe repayment of commercial loans may be substantially dependent on the successof the business itself.  Further, thecollateral for commercial loans may depreciate over time and cannot be appraisedwith as much precision as residential real estate.

 

To manage these risks, our policy is to secure thecommercial loans we make with both the assets of the borrowing business andother additional collateral and guarantees that may be

 

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available.  Inaddition, we actively monitor certain measures of the borrower, includingadvance rate, cash flow, collateral value and other appropriate credit factors.

 

*Commercial Mortgage Loans.*  We also originate commercialmortgage loans.  These loans areprimarily secured by various types of commercial real estate, including office,retail, warehouse, industrial and other non-residential types of properties andare made to the owners and/or occupiers of such property.  The majority of these loans have maturitiesgenerally ranging from one to ten years.

 

Commercial mortgage lending entails significantadditional risk compared with residential mortgage lending.  Commercial mortgage loans typically involvelarger loan balances concentrated with single borrowers or groups of relatedborrowers.  Additionally, the repaymentof loans secured by income-producing properties is typically dependent on thesuccessful operation of a business or a real estate project and thus may besubject, to a greater extent than is the case with residential mortgage loans,to adverse conditions in the real estate market or in the economygenerally.  Our commercial real estateloan underwriting criteria require an examination of debt service coverageratios, the borrower’s creditworthiness and prior credit history andreputation, and we generally require personal guarantees or endorsements withrespect to these loans.  We alsocarefully consider the location of the property that will be collateral for theloan in the loan underwriting process.

 

Loan-to-value ratios for commercial mortgage loansgenerally do not exceed 75%.  We permitloan-to-value ratios up to 80% if the property is owner occupied and theborrower has unusually strong liquidity, net worth and cash flow.

 

*Residential Mortgage Loans.*  Our residential mortgage loansconsist of residential first and second mortgage loans, residentialconstruction loans and home equity lines of credit and term loans secured byfirst and second mortgages on the residences of borrowers for homeimprovements, education and other personal expenditures.  We make mortgage loans with a variety ofterms, including fixed and floating or variable rates and a variety ofmaturities.

 

Residentialmortgage loans generally are made on the basis of the borrower’s ability torepay the loan from his or her employment and other income and are secured byresidential real estate, the value of which tends to be easilyascertainable.  These loans are madeconsistent with our appraisal and real estate lending policies, which detailmaximum loan-to-value ratios and maturities. Residential mortgage loans and home equity lines of credit secured byowner-occupied property generally are made with a loan-to-value ratio of up to80%.  Loan-to-value ratios of up to 90%may be allowed on residential owner-occupied property if the borrower exhibitsunusually strong general liquidity, net worth and cash flow.

 

*Construction Loans.*  Ourconstruction loan portfolio consists of single-family residential properties,multi-family properties and commercial projects.  Construction lending entails significant additional riskscompared with residential mortgage lending. Construction loans often involve larger loan balances concentrated withsingle borrowers or groups of related borrowers.  Construction loans also involve additional risks in that loanfunds are advanced upon the security of property under construction, which isof uncertain value prior to the completion of construction.  Thus, it is more difficult to evaluateaccurately the total loan funds required to complete a project and relatedloan-to-value ratios.  To minimize therisks associated with construction lending, we limit loan-to-value ratios forowner occupied residential or commercial properties to 80%, and for investor-ownedresidential or commercial properties to 75% of when-completed appraisedvalues.  We expect that theloan-to-value ratios will be sufficient to

 

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compensate for fluctuations in the realestate market to minimize the risk of loss. Maturities for construction loans generally range from six to 12 monthsfor residential property and from 12 to 24 months for non-residential andmulti-family properties.

 

*Consumer Loans.*  Ourconsumer loans consist primarily of installment loans made to individuals forpersonal, family and household purposes. The specific types of consumer loans we make include home improvementloans, debt consolidation loans and general consumer lending.

 

Consumerloans may entail greater risk than residential mortgage loans, particularly inthe case of consumer loans that are unsecured, such as lines of credit, orsecured by rapidly depreciable assets, such as automobiles.  In such cases, any repossessed collateralfor a defaulted consumer loan may not provide an adequate source of repaymentof the outstanding loan balance as a result of the greater likelihood ofdamage, loss or depreciation.  Theremaining deficiency often does not warrant further substantial collectionefforts against the borrower.  Inaddition, consumer loan collections are dependent on the borrower’s continuingfinancial stability, and thus are more likely to be adversely affected by jobloss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws,including federal and state bankruptcy and insolvency laws, may limit theamount that can be recovered on such loans. A loan may also give rise to claims and defenses by a consumer loan borroweragainst an assignee of such loan, such as the bank, and a borrower may be ableto assert against such assignee claims and defenses that it has against theseller of the underlying collateral.

 

Ourpolicy for consumer loans is to accept moderate risk while minimizing losses,primarily through a careful credit and financial analysis of the borrower.  In evaluating consumer loans, we require ourlending officers to review the borrower’s level and stability of income, pastcredit history, amount of currently outstanding debt and the impact of thesefactors on the ability of the borrower to repay the loan in a timelymanner.  In addition, we require ourbanking officers to maintain an appropriate margin between the loan amount andcollateral value.

 

Wealso issue credit cards to certain of our customers.  In determining to whom we will issue credit cards, we evaluatethe borrower’s level and stability of income, past credit history and otherfactors.  Finally, we make additionalloans that are not classified in one of the above categories.  In making such loans, we attempt to ensurethat the borrower meets our loan underwriting standards.

 

*Loan Participations*

 

Fromtime to time we purchase and sell loan participations to or from other bankswithin our market area.  All loanparticipations purchased have been underwritten using the bank’s standard andcustomary underwriting criteria and are in good standing.

 

*Deposits*

 

Weoffer a broad range of interest-bearing and noninterest-bearing depositaccounts, including commercial and retail checking accounts, money marketaccounts, individual retirement accounts, regular interest-bearing savingsaccounts and certificates of deposit with a range of maturity dateoptions.  The primary sources ofdeposits are small and medium-sized businesses and individuals within ourtarget market.  Senior management hasthe authority to set rates within specified parameters in order to remaincompetitive with other financial institutions in our market area.  We do not currently engage in the purchaseof any brokered deposits.  All depositsare

 

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insured by the Federal Deposit InsuranceCorporation up to the maximum amount permitted by law.  We implement a service charge fee schedule,which is competitive with other financial institutions in our market, coveringsuch matters as maintenance fees on checking accounts, per item processing feeson checking accounts, returned check charges and other similar fees.

 

*Courier Services*

 

Weoffer courier services to our business customers.  Courier services permit us to provide the convenience andpersonalized service that our customers require by scheduling pick-ups ofdeposits.

 

*Telephone and Internet Banking*

 

Webelieve that there is a strong demand within our market for telephone bankingand Internet banking.  Both servicesallow both commercial and retail customers to access detailed accountinformation and execute a wide variety of the banking transactions referred toabove.  We believe that these servicesare particularly attractive for our customers, as it enables them to conducttheir banking business and monitor their bank accounts from remote locationsand at anytime during the day or night. Telephone and Internet banking assistsus in attracting and retaining customers and encourages our existing customersto consider Cardinal for all of their banking and financial needs.

 

*Automatic Teller Machines*

 

Wehave an ATM at each of our branch offices and we make other financialinstitutions’ ATMs available to our customers.

 

*Other Products and Services*

 

Weoffer other banking-related specialized products and services to our customers,such as travelers checks and safe deposit services.  We do not currently engage in any interest rate hedgingactivities and are not involved in any off balance sheet transactions orrelationships, except for letters of credit issued on behalf of commercialcustomers in the ordinary course of business. We have not engaged in any securitizations of loans.

 

**Credit Policies**

 

Oursenior lending officers and chief credit officer are primarily responsible formaintaining a quality loan portfolio and developing a strong credit culturethroughout the entire organization.  Thechief credit officer is responsible for developing and updating our creditpolicies and procedures, which are approved by the board of directors.  Senior lending officers may make exceptionsto these credit policies and procedures as appropriate, but any such exceptionmust be approved by the chief credit officer, documented and made for soundbusiness reasons.

 

Credit quality is controlled by the chief creditofficer through compliance with our credit policies and procedures.  Our risk-decision process is activelymanaged in a disciplined fashion to maintain an acceptable risk profilecharacterized by soundness, diversity, quality, prudence, balance andaccountability.  Our credit approvalprocess consists of specific authorities granted to the lending officers.  Loans exceeding a particular lendingofficer’s level of authority are reviewed and considered for approval by anofficers’ loan committee and then by a committee of

 

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the bank’s board of directors.  In addition, the chief credit officer works closely with eachlending officer at the bank level to ensure that the business being solicitedis of the quality and structure that fits our desired risk profile.

 

Under our credit policies, we continually monitorour concentration of credit risk.  Wehave established a specific concentration limit for any individual or entity,any group of borrowers related as to the source of repayment or any onespecific industry.  Furthermore, thebank has established limits on the total amount of the bank’s outstanding loansto one borrower, all of which are set below legal lending limits.

 

##### **Brokerageand Investment Services**

 

We provide brokerage and investment services through a contract withRaymond James Financial Services, Inc.  Under this contract, financial advisors canoffer our customers an extensive range of financial products and services,including estate planning, qualified retirement plans, mutual funds, annuities,life insurance, fixed income securities and equity research andrecommendations.

 

InAugust 2003, we appointed Rex Wagner as President and Chief Executive Officerof Cardinal Wealth Services, Inc. to oversee the investment products andservices that we can offer our customers. Mr. Wagner had previously served as Manager of Raymond James &Associates, Inc.’s Washington, D.C. office.

 

**Employees**

 

At December31, 2003, we had 115 full-time employees and 14 part-time employees.  None of our employees are represented by anycollective bargaining unit.  We believeour relations with our employees are good.

 

**Government Supervision and Regulation**

 

*General*

 

As a bank holding company, we aresubject to regulation under the Bank Holding Company Act of 1956, as amended,and the examination and reporting requirements of the Board of Governors of theFederal Reserve System.  Other federaland state laws govern the activities of our bank subsidiary, including theactivities in which it may engage, the investments that it makes, the aggregateamount of loans that it may grant to one borrower, and the dividends it maydeclare.  Our bank subsidiary is alsosubject to various consumer and compliance laws.  As a national bank, Cardinal Bank, N.A., is subject to primaryregulation, supervision and examination by the Office of the Comptroller of theCurrency.  Our bank subsidiary also issubject to regulation, supervision and examination by the Federal DepositInsurance Corporation.

 

The following description summarizes the significant federal and statelaws applicable to us.  To the extentthat statutory or regulatory provisions are described, the description isqualified in its entirety by reference to that particular statutory orregulatory provision.

 

*The Bank Holding Company Act*

 

Under the Bank Holding CompanyAct, we are subject to periodic examination by the Federal Reserve and requiredto file periodic reports regarding our operations and any additional

 

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informationthat the Federal Reserve may require. Our activities at the bank holding company level are limited to:

 

•                  banking, managing or controllingbanks;

•                  furnishing services to orperforming services for our subsidiary; and

•                  engaging in other activities thatthe Federal Reserve has determined by regulation or order to be so closelyrelated to banking as to be a proper incident to these activities.

 

Some of the activities that the Federal Reserve Board has determined byregulation to be proper incidents to the business of a bank holding companyinclude making or servicing loans and specific types of leases, performingspecific data processing services and acting in some circumstances as afiduciary or investment or financial adviser.

 

With some limited exceptions, theBank Holding Company Act requires every bank holding company to obtain theprior approval of the Federal Reserve before:

 

•                  acquiring substantially all theassets of any bank;

•                  acquiring direct or indirectownership or control of any voting shares of any bank if after such acquisitionit would own or control more than 5% of the voting shares of such bank (unlessit already owns or controls the majority of such shares); or

•                  merging or consolidating withanother bank holding company.

 

In addition, and subject to someexceptions, the Bank Holding Company Act and the Change in Bank Control Act,together with their regulations, require Federal Reserve approval prior to anyperson or company acquiring “control” of a bank holding company.  Control is conclusively presumed to exist ifan individual or company acquires 25% or more of any class of voting securitiesof the bank holding company.  Control isrebuttably presumed to exist if a person acquires 10% or more, but less than25%, of any class of voting securities and either has registered securitiesunder Section 12 of the Securities Exchange Act of 1934 or no other person ownsa greater percentage of that class of voting securities immediately after thetransaction.  The regulations provide aprocedure for challenging this rebuttable control presumption.

 

In November 1999, Congress enacted the Gramm-Leach-Bliley Act, which madesubstantial revisions to the statutory restrictions separating bankingactivities from other financial activities. Under the GLBA, bank holding companies that are well-capitalized andwell-managed and meet other conditions can elect to become “financial holdingcompanies.”  As financial holdingcompanies, they and their subsidiaries are permitted to acquire or engage inpreviously impermissible activities such as insurance underwriting, securitiesunderwriting and distribution, travel agency activities, insurance agencyactivities, merchant banking and other activities that the Federal Reservedetermines to be financial in nature or complementary to these activities.  Financial holding companies continue to besubject to the overall oversight and supervision of the Federal Reserve, butthe GLBA applies the concept of functional regulation to the activitiesconducted by subsidiaries.  For example,insurance activities would be subject to supervision and regulation by stateinsurance authorities.  Although we havenot elected to become a financial holding company in order to exercise thebroader activity powers provided by the GLBA, we will likely elect to do so inthe future.

 

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*Payment of Dividends*

 

We are a legal entity separateand distinct from our banking and other subsidiaries.  Virtually all of our revenues will result from dividends paid tous by our bank subsidiary.  Our banksubsidiary is subject to laws and regulations that limit the amount ofdividends that it can pay.  Under theNational Bank Act, a national bank may not declare a dividend in excess of itsundivided profits, which means that our national bank subsidiary must recoverany start-up losses before it may pay a dividend to us.  Additionally, our national bank subsidiarymay not declare a dividend if the total amount of all dividends, including theproposed dividend, declared by the national bank in any calendar year exceedsthe total of the national bank’s retained net income of that year to date,combined with its retained net income of the two preceding years, unless thedividend is approved by the OCC.  Ournational bank subsidiary may not declare or pay any dividend if, after makingthe dividend, the national bank would be “undercapitalized,” as defined in the federalregulations.

 

Both the OCC and the FDIC havethe general authority to limit the dividends paid by national banks and insuredbanks if the payment is deemed an unsafe and unsound practice.  Both the OCC and the FDIC has indicated thatpaying dividends that deplete a bank’s capital base to an inadequate levelwould be an unsound and unsafe banking practice.

 

In addition, we are subject to certain regulatory requirements to maintaincapital at or above regulatory minimums. These regulatory requirements regarding capital affect our dividendpolicies.  Banking regulators haveindicated that banking organizations should generally pay dividends only if theorganization’s net income available to common shareholders over the past yearhas been sufficient to fully fund the dividends, and the prospective rate ofearnings retention appears consistent with the organization’s capital needs,asset quality and overall financial condition. Virginia law also imposes some restrictions on our ability to paydividends.

 

*Insurance of Accounts, Assessments andRegulation by the FDIC*

 

The deposits of our banksubsidiary are insured by the FDIC up to the limits set forth under applicablelaw.  The deposits of our banksubsidiary are subject to the deposit insurance assessments of the BankInsurance Fund, or “BIF”, of the FDIC.

 

The FDIC has implemented a risk-based deposit insurance assessment systemunder which the assessment rate for an insured institution may vary accordingto regulatory capital levels of the institution and other factors, includingsupervisory evaluations.  For example,depository institutions insured by the BIF that are “well capitalized” and thatpresent few or no supervisory concerns are required to pay only the statutoryminimum assessment of $2,000 annually for deposit insurance, while all otherbanks are required to pay premiums ranging from 0.03% to 0.27% of domesticdeposits.  These rate schedules aresubject to future adjustments by the FDIC. In addition to being influenced bythe risk profile of the particular depository institution, FDIC premiums arealso influenced by the size of the FDIC insurance fund in relation to totaldeposits in FDIC insured banks.  TheFDIC has authority to impose special assessments from time to time.

 

The FDIC is authorized to prohibit any BIF-insured institution fromengaging in any activity that the FDIC determines by regulation or order topose a serious threat to the respective insurance fund.  Also, the FDIC may initiate enforcementactions against banks, after first giving the institution’s primary regulatoryauthority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depositoryinstitution if it determines, after a hearing, that

 

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theinstitution has engaged or is engaging in unsafe or unsound practices, is in anunsafe or unsound condition to continue operations, or has violated anyapplicable law, regulation, order or any condition imposed in writing by theFDIC.  It also may suspend depositinsurance temporarily during the hearing process for the permanent terminationof insurance, if the institution has no tangible capital.  If deposit insurance is terminated, thedeposits at the institution at the time of termination, less subsequentwithdrawals, shall continue to be insured for a period from six months to twoyears, as determined by the FDIC.  Weare not aware of any existing circumstances that could result in termination ofany of our bank subsidiary’s deposit insurance.

 

*Capital Requirements*

 

Each of the OCC and the Federal Reserve Board hasissued risk-based and leverage capital guidelines applicable to bankingorganizations that it supervises.  Underthe risk-based capital requirements, we and our bank subsidiary are eachgenerally required to maintain a minimum ratio of total capital torisk-weighted assets (including specific off-balance sheet activities, such asstandby letters of credit) of 8%.  Atleast half of the total capital must be composed of “Tier 1 Capital”, which isdefined as common equity, retained earnings and qualifying perpetual preferredstock, less certain intangibles.  Theremainder may consist of “Tier 2 Capital”, which is defined as specificsubordinated debt, some hybrid capital instruments and other qualifyingpreferred stock and a limited amount of the loan loss allowance.  In addition, each of the federal bankingregulatory agencies has established minimum leverage capital requirements forbanking organizations.  Under theserequirements, banking organizations must maintain a minimum ratio of Tier 1capital to adjusted average quarterly assets equal to 3% to 5%, subject tofederal bank regulatory evaluation of an organization’s overall safety andsoundness.  In sum, the capital measuresused by the federal banking regulators are:

 

•                  the Total Risk-Based Capitalratio, which is the total of Tier 1 Risk-Based Capital and Tier 2 Capital;

 

•                  the Tier 1 Risk-Based Capitalratio; and

 

•                  the leverage ratio.

 

Under these regulations, anational bank will be:

 

•                  “well capitalized” if it has aTotal Risk-Based Capital ratio of 10% or greater, a Tier 1 Risk-Based Capitalratio of 6% or greater, a leverage ratio of 5% or greater, and is not subjectto any written agreement, order, capital directive, or prompt corrective actiondirective by a federal bank regulatory agency to meet and maintain a specificcapital level for any capital measure;

 

•                  “adequately capitalized” if ithas a Total Risk-Based Capital ratio of 8% or greater, a Tier 1 Risk-BasedCapital ratio of 4% or greater, and a leverage ratio of 4% or greater – or 3%in certain circumstances – and is not well capitalized;

 

•                  “undercapitalized” if it has aTotal Risk-Based Capital ratio of less than 8% or greater, a Tier 1Risk-Based Capital ratio of less than 4% (or 3% in certain circumstances), or aleverage ratio of less than 4% (or 3% in certain circumstances);

 

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•                  “significantly undercapitalized”if it has a Total Risk-Based Capital ratio of less than 6%, a Tier 1Risk-Based Capital ratio of less than 3%, or a leverage ratio of less than 3%;or

 

•                  “critically undercapitalized” ifits tangible equity is equal to or less than 2% of tangible assets.

 

The risk-based capital standards of each of the OCC and the FederalReserve Board explicitly identify concentrations of credit risk and the riskarising from non-traditional activities, as well as an institution’s ability tomanage these risks, as important factors to be taken into account by the agencyin assessing an institution’s overall capital adequacy.  The capital guidelines also provide that aninstitution’s exposure to a decline in the economic value of its capital due tochanges in interest rates be considered by the agency as a factor in evaluatinga banking organization’s capital adequacy.

 

The OCC and the FDIC may take various corrective actions against anyundercapitalized bank and any bank that fails to submit an acceptable capitalrestoration plan or fails to implement a plan accepted by the OCC or theFDIC.  These powers include, but are notlimited to, requiring the institution to be recapitalized, prohibiting assetgrowth, restricting interest rates paid, requiring prior approval of capitaldistributions by any bank holding company that controls the institution,requiring divestiture by the institution of its subsidiaries or by the holdingcompany of the institution itself, requiring new election of directors, andrequiring the dismissal of directors and officers.  Our bank subsidiary presently maintains sufficient capital toremain in compliance with these capital requirements.

 

*Other Safety and Soundness Regulations*

 

There are a number of obligations and restrictions imposed on bankholding companies and their depository institution subsidiaries by federal lawand regulatory policy that are designed to reduce potential loss exposure tothe depositors of such depository institutions and to the FDIC insurance fundsin the event that the depository institution is insolvent or is in danger ofbecoming insolvent.  These obligationsand restrictions are not for the benefit of investors.  Regulators may pursue an administrativeaction against any bank holding company or national bank which violates thelaw, engages in an unsafe or unsound bank practice or which is about to engagein an unsafe and unsound banking practice. The administrative action could take the form of a cease and desistproceeding, a removal action against the responsible individuals or, in thecase of a violation of law or unsafe and unsound banking practice, a civilpenalty action.  A cease and desistorder, in addition to prohibiting certain action, could also require thatcertain action be undertaken.  Under thepolicies of the Federal Reserve Board, we are required to serve as a source offinancial strength to our subsidiary depository institution and to commitresources to support the bank in circumstances where we might not do sootherwise.

 

*Interstate Banking and Branching*

 

Current federal law authorizesinterstate acquisitions of banks and bank holding companies without geographiclimitation.  Effective June 1,1997, a bank headquartered in one state is authorized to merge with a bankheadquartered in another state, as long as neither of the states had opted outof such interstate merger authority prior to such date.  For example, as a bank headquartered inVirginia, we may acquire a bank or branch in Maryland, but we cannot simplyestablish a branch in Maryland.  After abank has established a branch in a state through an interstate mergertransaction, the bank may establish and acquire additional branches at any

 

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locationin the state where a bank headquartered in that state could have established oracquired branches under applicable federal or state law.

 

*Monetary Policy*

 

The commercial banking business is affected not only by generaleconomic conditions but also by the monetary policies of the Federal ReserveBoard.  The instruments of monetarypolicy employed by the Federal Reserve Board include open market operations inUnited States government securities, changes in the discount rate on memberbank borrowing and changes in reserve requirements against deposits held by allfederally insured banks.  The FederalReserve Board’s monetary policies have had a significant effect on theoperating results of commercial banks in the past and are expected to continueto do so in the future.  In view ofchanging conditions in the national and international economy and in the moneymarkets, as well as the effect of actions by monetary fiscal authorities,including the Federal Reserve Board, no prediction can be made as to possiblefuture changes in interest rates, deposit levels, loan demand or the businessand earnings of our bank subsidiary.

 

*Federal Reserve System*

 

In 1980, Congress enacted legislation that imposed reserve requirementson all depository institutions that maintain transaction accounts ornonpersonal time deposits.  NOWaccounts, money market deposit accounts and other types of accounts that permitpayments or transfers to third parties fall within the definition oftransaction accounts and are subject to these reserve requirements, as are anynonpersonal time deposits at an institution. For net transaction accounts in 2003, the first $5.7 million will beexempt from reserve requirements.  A 3%reserve ratio will be assessed on net transaction accounts over $5.7 million toand including $41.3 million.  A 10%reserve ratio will be applied to net transaction accounts in excess of $41.3million.  These percentages are subjectto adjustment by the Federal Reserve Board. Because required reserves must be maintained in the form of vault cashor in a non-interest-bearing account at, or on behalf of, a Federal ReserveBank, the effect of the reserve requirement is to reduce the amount of theinstitution’s interest-earning assets.

 

*Transactions with Affiliates*

 

Transactions between banks and their affiliates are governed bySections 23A and 23B of the Federal Reserve Act.  An affiliate of a bank is any bank or entity that controls, iscontrolled by or is under common control with such bank.  Generally, Sections 23A and 23B (i) limitthe extent to which the bank or its subsidiaries may engage in “coveredtransactions” with any one affiliate to an amount equal to 10% of suchinstitution’s capital stock and surplus, and maintain an aggregate limit on allsuch transactions with affiliates to an amount equal to 20% of such capitalstock and surplus, and (ii) require that all such transactions be on termssubstantially the same, or at least as favorable, to the bank as those providedto a nonaffiliate.  The term “coveredtransaction” includes the making of loans, purchase of assets, issuance of a guaranteeand similar other types of transactions. Section 23B applies to “covered transactions” as well as sales of assetsand payments of money to an affiliate. These transaction must also be conducted on terms substantially thesame, or at least favorable, to the bank as those provided to nonaffiliates.

 

*Loans to Insiders*

 

The Federal Reserve Act and related regulations impose specificrestrictions on loans to directors, executive officers and principalshareholders of banks.  Under Section22(h) of the

 

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Federal Reserve Act, loans to adirector, an executive officer and to a principal shareholder of a bank, and toentities controlled by any of the foregoing, may not exceed, together with allother outstanding loans to such person and entities controlled by such person,the bank’s loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as aclass may not exceed two times the bank’s unimpaired capital and unimpairedsurplus until the bank’s total assets equal or exceed $100,000,000, at whichtime the aggregate is limited to the bank’s unimpaired capital and unimpairedsurplus.  Section 22(h) also prohibitsloans, above amounts prescribed by the appropriate federal banking agency, todirectors, executive officers and principal shareholders of a bank or bankholding company, and to entities controlled by such persons, unless such loanis approved in advance by a majority of the board of directors of the bank withany “interested” director not participating in the voting.  The OCC has prescribed the loan amount,which includes all other outstanding loans to such person, as to which suchprior board of director approval is required, as being the greater of $25,000or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers andprincipal shareholders be made on terms and underwriting standardssubstantially the same as offered in comparable transactions to other persons.

 

*Community Reinvestment Act*

 

Under the Community Reinvestment Act and related regulations,depository institutions have an affirmative obligation to assist in meeting thecredit needs of their market areas, including low and moderate-income areas,consistent with safe and sound banking practice.  The Community Reinvestment Act requires the adoption by eachinstitution of a Community Reinvestment Act statement for each of its marketareas describing the depository institution’s efforts to assist in itscommunity’s credit needs.  Depositoryinstitutions are periodically examined for compliance with the CommunityReinvestment Act and are periodically assigned ratings in this regard.  Banking regulators consider a depositoryinstitution’s Community Reinvestment Act rating when reviewing applications toestablish new branches, undertake new lines of business, and/or acquire part orall of another depository institution. An unsatisfactory rating can significantly delay or even prohibitregulatory approval of a proposed transaction by a bank holding company or itsdepository institution subsidiaries.

 

TheGramm-Leach-Bliley Act and federal bank regulators have made various changes tothe Community Reinvestment Act.  Amongother changes, Community Reinvestment Act agreements with private parties mustbe disclosed and annual reports must be made to a bank’s primary federalregulatory. A bank holding company will not be permitted to become a financialholding company and no new activities authorized under the GLBA may becommenced by a holding company or by a bank financial subsidiary if any of itsbank subsidiaries received less than a “satisfactory” rating in its latestCommunity Reinvestment Act examination.

 

*Fair Lending; Consumer Laws*

 

In addition to the Community Reinvestment Act, other federal and statelaws regulate various lending and consumer aspects of the bankingbusiness.  Governmental agencies,including the Department of Housing and Urban Development, the Federal TradeCommission and the Department of Justice, have become concerned thatprospective borrowers experience discrimination in their efforts to obtainloans from depository and other lending institutions.  These agencies have brought litigation against depositoryinstitutions alleging discrimination against borrowers.  Many of these suits have been settled, insome cases for material sums, short of a full trial.

 

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Recently, these governmental agencies have clarified what they considerto be lending discrimination and have specified various factors that they willuse to determine the existence of lending discrimination under the Equal CreditOpportunity Act and the Fair Housing Act, including evidence that a lenderdiscriminated on a prohibited basis, evidence that a lender treated applicantsdifferently based on prohibited factors in the absence of evidence that thetreatment was the result of prejudice or a conscious intention to discriminate,and evidence that a lender applied an otherwise neutral non-discriminatorypolicy uniformly to all applicants, but the practice had a discriminatoryeffect, unless the practice could be justified as a business necessity .

 

Banks and other depositoryinstitutions also are subject to numerous consumer-oriented laws andregulations.  These laws, which include theTruth in Lending Act, the Truth in Savings Act, the Real Estate SettlementProcedures Act, the Electronic Funds Transfer Act, the Equal Credit OpportunityAct, and the Fair Housing Act, require compliance by depository institutionswith various disclosure requirements and requirements regulating theavailability of funds after deposit or the making of some loans to customers.

 

*Gramm-Leach-Bliley Act of 1999*

 

The Gramm-Leach-Bliley Act of1999 was signed into law on November 12, 1999. The GLBA covers a broad range of issues, including a repeal of most ofthe restrictions on affiliations among depository institutions, securitiesfirms and insurance companies.  Most ofits provisions require the federal bank regulatory agencies and otherregulatory bodies to adopt implementing regulations, and for that reason anassessment of the full impact of the GLBA on us must await completion of thatregulatory process.  The followingdescription summarizes some of its significant provisions.

 

The GLBA repeals sections 20 and 32 of the Glass-Steagall Act, thuspermitting unrestricted affiliations between banks and securities firms.  It also permits bank holding companies toelect to become financial holding companies. A financial holding company may engage in or acquire companies thatengage in a broad range of financial services, including securities activitiessuch as underwriting, dealing, investment, merchant banking, insuranceunderwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding companyand all of its affiliated depository institutions must be well-capitalized,well-managed and have at least a satisfactory Community Reinvestment Actrating.

 

The GLBA provides that the states continue to have the authority toregulate insurance activities, but prohibits the states in most instances frompreventing or significantly interfering with the ability of a bank, directly orthrough an affiliate, to engage in insurance sales, solicitations orcross-marketing activities.  Althoughthe states generally must regulate bank insurance activities in anondiscriminatory manner, the states may continue to adopt and enforce rulesthat specifically regulate bank insurance activities in specific areasidentified under the law.  Under the newlaw, the federal bank regulatory agencies adopted insurance consumer protectionregulations that apply to sales practices, solicitations, advertising anddisclosures.

 

The GLBA adopts a system of functional regulation under which the FederalReserve Board is designated as the umbrella regulator for financial holdingcompanies, but financial holding company affiliates are principally regulatedby functional regulators such as the OCC for national bank affiliates, theSecurities and Exchange Commission for securities affiliates, and stateinsurance regulators for insurance affiliates. It repeals the broad exemption of banks from the definitions of “broker”and “dealer” for purposes of the Securities Exchange Act of 1934, asamended.  It also identifies a set ofspecific activities, including traditional bank trust and

 

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fiduciaryactivities, in which a bank may engage without being deemed a “broker,” and aset of activities in which a bank may engage without being deemed a“dealer.”  Additionally, the new lawmakes conforming changes in the definitions of “broker” and “dealer” forpurposes of the Investment Company Act of 1940, as amended, and the InvestmentAdvisers Act of 1940, as amended.

 

The GLBA contains extensive customer privacy protection provisions.  Under these provisions, a financialinstitution must provide to its customers, both at the inception of thecustomer relationship and on an annual basis, the institution’s policies andprocedures regarding the handling of customers’ nonpublic personal financialinformation.  The new law provides that,except for specific limited exceptions, an institution may not provide suchpersonal information to unaffiliated third parties unless the institutiondiscloses to the customer that such information may be so provided and thecustomer is given the opportunity to opt out of such disclosure.  An institution may not disclose to anon-affiliated third party, other than to a consumer reporting agency, customeraccount numbers or other similar account identifiers for marketingpurposes.  The GLBA also provides thatthe states may adopt customer privacy protections that are more strict thanthose contained in the act.

 

*Future Regulatory Uncertainty*

 

Because federal regulation of financial institutions changes regularlyand is the subject of constant legislative debate, we cannot forecast howfederal regulation of financial institutions may change in the future andimpact our operations.  AlthoughCongress in recent years has sought to reduce the regulatory burden onfinancial institutions with respect to the approval of specific transactions,we fully expect that the financial institution industry will remain heavilyregulated in the near future and that additional laws or regulations may beadopted further regulating specific banking practices.

 

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**Item2.  Description of Property**

 

We conduct our business from our headquarters in Tysons Corner,Virginia and 12 branch banking offices. The following table provides certain information with respect to ourproperties:

 
| **Location:**                                                                            |   | **Date Facility Opened:** |   | **Ownership and Leasing Arrangements**                                                                                                                                       |
|------------------------------------------------------------------------------------------|--------|---------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                     |   |                      |   |
| Headquarters and Branch Office #1  8270 Greensboro Drive  McLean, Virginia 22102         |   | March, 2003               |   | We occupy approximately 45,000 square feet under a lease (including a  lobby-level branch office containing approximately 3,200 square feet) that  expires January 31, 2010. |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #2  Cardinal Bank, N.A.  10641 Lee Highway  Fairfax, Virginia 22030        |   | January, 1998             |   | This branch occupies a three-story brick structure, which contains  approximately 9,000 square feet under a lease that expires December 31,  2007.                      |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #3  Cardinal Bank, N.A.  1737 King Street  Alexandria, Virginia 22314      |   | June, 2000                |   | This branch occupies approximately 2,600 square feet under a lease  that expires December 31, 2013.                                                                          |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #4  Cardinal Bank, N.A.  11150 Sunset Hills Road  Reston, Virginia 20190   |   | August, 1999              |   | This branch occupies approximately 3,600 square feet of a three-story  structure under a lease that expires December 31, 2008.                                               |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #5  Cardinal Bank, N.A.  46005 Regal Plaza  Sterling, Virginia 20165       |   | September, 2000           |   | This branch occupies approximately 3,000 square feet under a lease  that expires February 28, 2009.                                                                          |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #6  Cardinal Bank, N.A.  1313 Dolley Madison Blvd.  McLean, Virginia 22101 |   | September, 2000           |   | This branch occupies approximately 2,200 square feet under a lease  that expires July 31, 2008.                                                                              |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #7  Cardinal Bank, N.A.  1650 Tysons Boulevard  McLean, Virginia 22102     |   | September, 2000           |   | This branch occupies approximately 4,100 square feet under a lease  that expires March 31, 2006.                                                                             |
|                                                                                     |   |                      |   |                                                                                                                                                                         |
| Branch Office #8  Cardinal Bank, N.A.  9626 Center Street  Manassas, Virginia 20110      |   | July, 1999                |   | This branch occupies a two-story building containing approximately  6,000 square feet and owned by us. We have leased 3,000 square feet of this  building during 2002.       |

 

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| **Location:**                                                                            |   | **Date Facility Opened:** |   | **Ownership and Leasing Arrangements**                                                              |
|------------------------------------------------------------------------------------------|--------|---------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                                                                                     |   |                      |   |
| Branch Office #9  Cardinal Bank, N.A.  2100 N. Glebe Road  Arlington, Virginia 22207     |   | September, 2002           |   | This branch occupies approximately 1,200 square feet under a lease  that expires August 31, 2007.   |
|                                                                                     |   |                      |   |                                                                                                |
| Branch Office #10  Cardinal Bank, N.A.  20 Catoctin Circle  Leesburg, Virginia 20175     |   | October, 2003             |   | This branch occupies approximately 2,600 square feet under a lease  that expires December 31, 2008. |
|                                                                                     |   |                      |   |                                                                                                |
| Branch Office #11  Cardinal Bank, N.A.  13870 Smoketown Road  Woodbridge, Virginia 22193 |   | December, 2003            |   | This branch occupies approximately 2,800 square feet and is owned by  us.                           |
|                                                                                     |   |                      |   |                                                                                                |
| Branch Office #12  Cardinal Bank, N.A.  199 Elden Street  Herndon, Virginia 22070        |   | February, 2004            |   | This branch occupies approximately 2,900 square feet and is owned by  us.                           |

 

We believe that all of our properties are maintained in good operatingcondition and are suitable and adequate for our operational needs.

 

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**Item3.  Legal Proceedings**

 

In the ordinary course of our operations, we may become party to legalproceedings.  Currently, we are notparty to any material proceedings and no such proceedings are, to management’sknowledge, threatened against us.

 

## **Item4.  Submission of Mattes to a Vote ofSecurity Holders**

 

No matters were submitted to a voteof security holders, through the solicitation of proxies or otherwise, duringthe fourth quarter of 2003.

 

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## **PART II.**

 

### **Item 5. Market for Common Equity and Related Stockholder Matters**

 

Our common stock is currently listed for quotationon the Nasdaq National Market under the symbol "CFNL."  Prior to December 17, 2003, our common stockwas listed for quotation on the Nasdaq SmallCap Market under the samesymbol.  As of December 31, 2003, ourcommon stock was held by 377 shareholders of record.  In addition, we estimate that there were 3,642 beneficial ownersof our common stock who own their shares through brokers or banks.

 

The high and low sale prices per share for ourcommon stock for each quarter of 2002 and 2003, as reported on the NasdaqNational Market and the Nasdaq SmallCap Market prior to December 17, 2003, wereas follows:

 
| **Periods Ended** |   | **High** |   | **Low** |   |
|-------------------|--------|----------|--------|---------|--------|
| 2002              |   |     |   |    |   |
| First Quarter     |   | $        | 6.50   |    | $      | 3.60 |   |
| Second Quarter    |   | 5.85     |   | 4.86    |   |
| Third Quarter     |   | 4.96     |   | 4.02    |   |
| Fourth Quarter    |   | 4.50     |   | 4.01    |   |
| 2003              |   |     |   |    |   |
| First Quarter     |   | 5.45     |   | 4.30    |   |
| Second Quarter    |   | 7.01     |   | 5.13    |   |
| Third Quarter     |   | 7.08     |   | 6.10    |   |
| Fourth Quarter    |   | 8.60     |   | 6.40    |   |
|                   |        |          |        |         |        |  |  |

 

We have notdeclared or distributed any cash dividends to the holders of our common shares,and it is not likely that we will declare any cash dividends on our commonshares in the foreseeable future.  Adividend accrues on the 7.25% Cumulative Convertible Preferred Stock, Series A,at the rate of $0.3625 per share per annum. This dividend is payable, at the discretion of the board of directors,on a quarterly basis.  To date, we havepaid the dividend to the holders of the 7.25% Cumulative Convertible PreferredStock, Series A.  Our board of directorsintends to follow a policy of retaining any earnings to provide funds tooperate and expand our business for the foreseeable future.  Our future dividend policy is subject to thediscretion of the board of directors and will depend upon a number of factors,including future earnings, financial condition, cash requirements, and generalbusiness conditions.

 

Our ability todistribute cash dividends will depend primarily on the abilities of oursubsidiaries to pay dividends to us.  Asa national bank, Cardinal Bank, N.A. is subject to legal limitations on theamount of dividends it is permitted to pay. Furthermore, neither Cardinal Bank, N.A. nor we, may declare or pay acash dividend on any of our capital stock if we are insolvent or if the paymentof the dividend would render us insolvent or unable to pay our obligations asthey become due in the ordinary course of business.  For additional information on these limitations, see “GovernmentRegulation and Supervision – Payment of Dividends” in Item 1 above.

 

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**Item 6. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

** **

Thefollowing presents management’s discussion and analysis of our consolidatedfinancial condition at December 31, 2003 and 2002 and the results of ouroperations for the years ended December 31, 2003, 2002 and 2001.  The discussion should be read in conjunctionwith the accompanying consolidated financial statements.

 

**Overview**

** **

**Cardinal Financial Corporation (“Cardinal”), a locallyowned and managed financial services organization headquartered in TysonsCorner, Virginia, is committed to providing top quality customer service, adiversified product mix and convenient avenues for banking to consumers andbusinesses.  We own Cardinal Bank, N.A.,a nationally chartered community bank, and Cardinal Wealth Services, Inc., aninvestment services subsidiary.  Throughthese two subsidiaries, we offer a wide range of banking products and servicesto both our commercial and retail customers. Our commercial relationship managers focus on attracting small andmedium-sized business as well as commercial real estate developers and buildersand professionals, such as physicians, accountants and attorneys.  We have an expansive retail branch networkand develop competitive retail products and services.  We complement our core banking operations by offering investmentproducts and services to our customers through our third-party brokeragerelationship with Raymond James Financial Services, Inc.**

 

Net interest income is our primary source ofincome.  As discussed further in ourinterest rate sensitivity section, we manage our balance sheet and interestrate risk to enhance our net interest income. We do this by monitoring the spread between the interest rates earned oninvestment securities and loans and the interest rate paid on deposits andother interest-bearing liabilities. Changes in interest rates will affect our operating performance andfinancial condition.  We attempt tominimize our exposure to interest rate risk, but are unable to eliminateit.  In addition to management ofinterest rate risk, we analyze our loan portfolio for exposure to creditrisk.  Risk of loan defaults andforeclosures are unavoidable in the banking industry, and we try to limit ourexposure to this risk by monitoring our extensions of credit carefully.  In addition to net interest income,non-interest income is a source of income for us and includes service chargeson deposits and loans, investment fee income and gains on sales on investmentsecurities available-for-sale.

** **

**Our business strategy is to grow through geographicexpansion while maintaining strong asset quality and achieving sustained profitability.  We completed a secondary common stockoffering that raised $41.7 million in capital in December 2003 and anadditional $6.7 million in capital following the exercise of the underwriters’over-allotment option in January 2004. This capital is being used to support the expansion of our branch officenetwork and balance sheet growth.  Wewere able to increase our legal lending limit to over $12 million, which willallow us to expand our commercial and real estate lending loan portfolios.  We expect to increase our loan-to-depositratio and shift the mix of our earning assets to higher yielding loans.  We intend to increase our selection ofbanking products and financial services in order to diversify our revenue base,increase fee income, and strengthen customer relationships.**

** **

24

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**Recent Financial Developments**

 

**Prior to March 2002, Cardinal was a multi-bankorganization.  In addition to CardinalBank, N.A., which began operations in 1998, we opened two additional bankingsubsidiaries in 1999, and acquired an additional banking subsidiary through ouracquisition of Heritage Bancorp, Inc. in 2000. From November 2001 to March 2002, we consolidated three of our bankingsubsidiaries into Cardinal Bank, N.A. We completed the consolidation of our original four banking subsidiariesinto a single bank in order to reduce costs and streamline operations anddecision-making.**

 

We were required to evaluate ourgoodwill for impairment and, in the fourth quarter of 2001, we had an $8.3million impairment of goodwill, substantially eliminating the goodwillattributable to the purchase of Heritage Bancorp, Inc.  The writedown arose from our evaluation oflosses incurred by the Heritage banking subsidiary during 2000 and 2001,coupled with expectations of future additional losses.  A valuation of the bank was performed by anexternal consultant in response to these impairment indicators.  The valuation confirmed a significantimpairment in our investment in Heritage and resulted in the write down ofgoodwill.

 

As a result of the bankconsolidation, we reduced staffing levels during the fourth quarter of 2001. Wereduced our number of employees from 138 on June 30, 2001 to 105 as of December31, 2001.  Most of the staff reductionswere made in the commercial lending area of the bank, which had becomeoverstaffed in light of the shift in strategy from four banks to one.  We also made significant reductions in staffin our centralized administration areas, including accounting, depositoperations and credit administration.

** **

**Ourrestructuring resulted in significant savings in operating costs during2002.  However, an other than temporarywrite down of $1.7 million on a WorldCom bond recorded in the second quarter of2002, created a reported net loss to common shareholders of $1.0 million forthe year ended December 31, 2002.**

** **

**2003 was our first full year of profitability for theCompany.  We reported net income of $5.7million or $0.54 per diluted common share in 2003.  Included in this net income, we recorded an income tax benefit of$3.5 million attributable to the recognition of a deferred tax asset resultingprimarily from prior periods’ net operating loss carryforwards.  The pretax profitability to commonshareholders in 2003 was $ 2.2 million, which was achieved through continuedgrowth in our earning assets, as well as increases in non-interest income,mostly attributable to $1.4 million of realized gains on sales of investmentsecurities available-for-sale.  Thesesales were mostly from our mortgage-backed investment securitiesavailable-for-sale portfolio, which had accelerated prepayment speeds as aresult of the low mortgage rate environment during 2003.  We sold these securities with realized gainsand reinvested the funds in our loan and investment securities portfolio.  We do not expect to record such gains in thefuture, although we may sell portions of our available-for-sale investmentsecurities portfolio as needed for liquidity purposes.**

** **

**CriticalAccounting Policies**

 

*General*

 

Accountingpolicies generally accepted in the United States are complex and requiremanagement to apply significant judgment to various accounting, reporting, anddisclosure matters.  Management must useassumptions and estimates to apply these principles where actual measurementsare not possible or practical.  Thesepolicies are critical because they are highly dependent upon subjective orcomplex judgments, assumptions and estimates. Changes in such

 

25

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estimates may have a significant impact on theconsolidated financial statements. Actual results could differ from those estimates.

 

Theaccounting policies we view as critical to us are those relating to estimatesand judgments regarding the determination of the allowance for loan losses andthe valuation allowance for deferred tax assets.

 

#### ***Allowance for Loan Losses***

 

**We maintain the allowance for loan losses at a level thatrepresents management’s best estimate of known and inherent losses in the loanportfolio.  Both the amount of theprovision expense and the level of the allowance for loan losses are impactedby many factors, including general economic conditions, actual and expectedcredit losses, historical trends and specific conditions of the individualborrower.  As a part of our analysis, weuse comparative peer group data, duration factors and qualitative factors suchas levels of and trends in delinquencies and nonaccrual loans, national andlocal economic trends and conditions and concentrations of loans exhibitingsimilar risk profiles to support our estimates.**

** **

Creditlosses are an inherent part of our business and, although we believe themethodologies for determining the allowance for loan losses and the currentlevel of the allowance are adequate, it is possible that there may beunidentified losses in the portfolio that may become evident only at a futuredate.  Additional provisions for suchlosses, if necessary, would negatively impact earnings and would be recorded inthe commercial banking business segment.

 

Forpurposes of our loan loss reserve methodology, we categorize our loans into oneof five categories:  commercial andindustrial, commercial real estate (including construction), home equity linesof credit, residential mortgages, and consumer loans.  Peer group annual loss factors (in the absence of historicalresults) are applied to all categories and are adjusted by the projectedduration of the loan category and by the qualitative factors mentionedabove.  The indicated loss factorsresulting from this analysis are applied to each of the loan categories todetermine a reserve level for each of the five categories of loans.  In addition, we individually assign lossfactors to all loans that have been identified as having loss attributes, asindicated by deterioration in the financial condition of the borrower or adecline in underlying collateral values. Since we have limited historical data on which to base loss factors for classifiedloans, we apply, in accordance with regulatory guidelines, a 5% loss factor toall special mention loans and a 15% loss factor to all substandard loans.

 

#### ***Valuation of Deferred Tax Assets***

 

Deferredtax assets and liabilities are recognized for the tax effects of differingcarrying values of assets and liabilities for tax and financial statementpurposes that will reverse in future periods. When substantial uncertainty exists concerning the recoverability of adeferred tax asset, the carrying value of the asset is reduced by a valuation allowance.  During the fourth quarter of 2003, werecorded an income tax benefit of $3.5 million primarily attributable to therecognition of deferred tax assets related to our net operating losscarryforwards.  The benefit of ourdeferred tax assets was recognized based on a detailed assessment indicatingthat it is more likely than not that the benefit of these net operating losseswould be realized through the generation of future taxable income.  Additional information on the valuationallowance can be found in Footnote 9 to the Notes to Consolidated FinancialStatements.

 

26

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**CautionAbout Forward-Looking Statements**

 

We make forward-looking statementsin this Form 10-KSB that are subject to risks and uncertainties.  These forward looking statements includestatements regarding our profitability, liquidity, allowance for loan losses,interest rate sensitivity, market risk, growth strategy, and financial andother goals.  The words “believes,”“expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,”“forecasts,” “intends,” or other similar words or terms are intended toidentify forward-looking statements.

 

These forward-looking statements are subject to significantuncertainties because they are based upon or are affected by factors including:

 

•                  the ability to successfully manage our growth or implement our growthstrategies if we are unable to identify attractive markets, locations oropportunities to expand in the future;

•                  changes in interest rates and interest rate policies;

•                  risks inherent in making loans such as repayment risks and fluctuatingcollateral values;

•                  the successful management of interest rate risk;

•                  maintaining cost controls and asset qualities as we open or acquire newbranches;

•                  maintaining capital levels adequate to support our growth;

•                  reliance on our management team, including our ability to attract andretain key personnel;

•                  competition with other banks and financial institutions, and companiesoutside of the banking industry, including those companies that havesubstantially greater access to capital and other resources;

•                  changes in general economic and business conditions in our market area;

•                  demand, development and acceptance of new products and services;

•                  problems with technology utilized by us;

•                  changing trends in customer profiles and behavior; and

•                  changes in banking and other laws and regulations applicable to us.

 

Because of these uncertainties, ouractual future results may be materially different from the results indicated bythese forward-looking statements.  Inaddition, our past results of operations do not necessarily indicate our futureresults.

 

###### **NewFinancial Accounting Standards**

 

In January 2003, the Financial Accounting Standards Board, or FASB,issued Interpretation No. 46 (FIN 46), *Consolidation of Variable Interest Entities,*which addresses how a business enterprise should evaluate whether it has acontrolling financial interest in an entity through means other than votingrights and accordingly should consolidate the entity.  FIN 46 Revised (FIN 46R), issued in December 2003, replaces FIN46.  FIN 46R requires public entities toapply FIN 46 or FIN 46R to all entities that are considered special-purposeentities in practice and under the FASB literature that was applied before theissuance of FIN 46 by the end of the first reporting period ending afterDecember 15, 2003.  For any variableinterest entities (VIE) that must be consolidated under FIN 46R, the assets,liabilities and noncontrolling interests of the VIE initially would be measuredat their carrying amounts with any difference between the net amount added tothe balance sheet and any previously recognized interest being recognized asthe cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value atthe date FIN 46R first applies may be used to measure the assets, liabilitiesand noncontrolling interest of the VIE. We adopted FIN 46R as of December 31,2003

 

27

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and currently have no variableinterest entities that require consolidation of previously unconsolidatedentities or disclosure in the consolidated financial statements.

 

InApril 2003, the FASB issued Statement No. 149, *Amendment of Statement 133 onDerivative Instruments and Hedging Activities,* which is generally effective forcontracts entered into or modified after June 30, 2003.  This Statement amends and clarifiesfinancial accounting and reporting for derivative instruments embedded in othercontracts, collectively referred to as “derivatives” and hedging activitiesunder Statement No. 133.  Statement No.149 has not had an impact on our equity, financial condition or results ofoperations.

 

In May 2003, the FASB issued Statement No. 150, *Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.*  This Statement establishes standards forclassifying and measuring certain financial instruments that embody obligationsof the issuer and have characteristics of both liabilities and equity.  The provisions of Statement No. 150 becameeffective June 1, 2003, for all financial instruments created or modified afterMay 31, 2003, and otherwise became effective as of July 1, 2003.  The adoption of this standard did not have amaterial impact on our equity, financial condition, or operating results.

 

In December2003, the FASB deferred for an indefinite period the application of theguidance in Statement No. 150 to noncontrolling interests that are classifiedas equity in the financial statements of a subsidiary but would be classifiedas a liability in the parent’s financial statements under Statement No.150.  The deferral is limited tomandatorily redeemable noncontrolling interests associated with finite-livedsubsidiaries.  Management does notbelieve any such applicable entities exist as of December 31, 2003.

 

InNovember 2002, the FASB issued Interpretation No. 45, *Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers,* whichaddresses the disclosures to be made by a guarantor in its interim and annualfinancial statements about its obligations under guarantees.  FIN 45 also requires the recognition of aliability by a guarantor at the inception of certain guarantees.  The liability is recognized for thenon-contingent component of the guarantee, which is the obligation to standready to perform in the event that specified triggering events or conditionsoccur.  The initial measurement of thisliability is the fair value of the guarantee at inception.  The recognition of the liability is requiredeven if it is not probable that payments will be required under the guarantee,or if the guarantee was issued with a premium payment, or as part of atransaction with multiple elements.  Wecurrently have $3.3 million of standby letters of credit that requireaccounting and disclosure under FIN 45. No liability has been recorded as of December 31, 2003 and December 31,2002, as such amounts were immaterial.

 

**Selected Financial Information**

(In thousands, except per share data)

 
|                                                             |   | **Years Ended December 31,** |    |
|------------------------------------------------------------------|--------|------------------------------|---------|
|                                                             |   | **2003**                     |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| **Income Statement Data:**                                       |   |                         |    |   |   |   |   |   |   |   |   |
| Interest income                                                  |   | $                            | 24,602  |   | $ | 20,242 |   | $ | 16,577 |   | $ | 11,150 |   | $ | 4,330 |   |
| Interest expense                                                 |   | 9,429                        |    | 9,586 |   | 7,500 |   | 4,740 |   | 1,305 |   |
| Net interest income                                              |   | 15,173                       |    | 10,656 |   | 9,077 |   | 6,410 |   | 3,025 |   |
| Provision for loan losses                                        |   | 1,001                        |    | 444 |   | 1,202 |   | 753 |   | 514 |   |
| Net interest income after provision for loan  losses             |   | 14,172                       |    | 10,212 |   | 7,875 |   | 5,657 |   | 2,511 |   |
| Non-interest income                                              |   | 3,829                        |    | 2,864 |   | 3,157 |   | 2,098 |   | 1,320 |   |
| Non-interest expense                                             |   | 15,355                       |    | 13,605 |   | 23,756 |   | 11,726 |   | 7,870 |   |
| Net income (loss) before income taxes                            |   | 2,646                        |    | (529 | ) | (12,724 | ) | (3,971 | ) | (4,039 | ) |
| Income tax benefit                                               |   | (3,508                       | )       | — |   | — |   | — |   | — |   |
| Net income (loss)                                                |   | 6,154                        |    | (529 | ) | (12,724 | ) | (3,971 | ) | (4,039 | ) |
| Dividends to preferred shareholders                              |   | 495                          |    | 495 |   | 503 |   | 171 |   | — |   |
| Net income (loss) to common shareholders                         |   | $                            | 5,659   |   | $ | (1,024 | ) | $ | (13,227 | ) | $ | (4,142 | ) | $ | (4,039 | ) |
|                                                             |   |                         |    |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                          |   |                         |    |   |   |   |   |   |   |   |   |
| Total assets                                                     |   | $                            | 636,248 |   | $ | 486,323 |   | $ | 279,584 |   | $ | 207,048 |   | $ | 97,033 |   |
| Loans receivable, net of fees                                    |   | 336,002                      |    | 249,106 |   | 200,911 |   | 154,271 |   | 68,167 |   |
| Allowance for loan losses                                        |   | 4,344                        |    | 3,372 |   | 3,104 |   | 1,900 |   | 726 |   |
| Total investment securities                                      |   | 273,614                      |    | 163,665 |   | 34,147 |   | 6,935 |   | 4,807 |   |
| Total deposits                                                   |   | 474,129                      |    | 423,479 |   | 246,024 |   | 163,371 |   | 59,873 |   |
| Other borrowed funds                                             |   | 74,457                       |    | 2,000 |   | 9,824 |   | 7,287 |   | 6,000 |   |
| Total shareholders’ equity                                  |   | 85,412                       |    | 40,712 |   | 20,624 |   | 34,112 |   | 30,745 |   |
| Preferred shares outstanding                                     |   | 1,364                        |    | 1,365 |   | 1,365 |   | 1,411 |   | — |   |
| Common shares outstanding                                        |   | 16,377                       |    | 10,044 |   | 4,294 |   | 4,253 |   | 4,243 |   |
|                                                             |   |                         |    |   |   |   |   |   |   |   |   |
| **Per Common Share Data:**                                       |   |                         |    |   |   |   |   |   |   |   |   |
| Basic net income (loss)                                          |   | $                            | 0.55    |   | $ | (0.13 | ) | $ | (3.11 | ) | $ | (0.98 | ) | $ | (0.95 | ) |
| Fully diluted net income (loss)                                  |   | 0.54                         |    | (0.13 | ) | (3.11 | ) | (0.98 | ) | (0.95 | ) |
| Book value                                                       |   | 4.80                         |    | 3.37 |   | 3.21 |   | 6.36 |   | 7.25 |   |
| Tangible book value                                              |   | 4.80                         |    | 3.31 |   | 3.06 |   | 4.11 |   | 7.25 |   |
|                                                             |   |                         |    |   |   |   |   |   |   |   |   |
| **Performance Ratios:**                                          |   |                         |    |   |   |   |   |   |   |   |   |
| Return on average assets                                         |   | 1.18                         | %       | (0.14% | ) | (5.24% | ) | (2.72% | ) | (5.61% | ) |
| Return on average equity                                         |   | 15.05                        |    | (1.61 | ) | (39.14 | ) | (12.72 | ) | (12.26 | ) |
| Net interest margin (1)                                          |   | 3.00                         |    | 2.92 |   | 4.17 |   | 4.82 |   | 4.59 |   |
| Efficiency ratio (2)                                             |   | 80.81                        |    | 100.63 |   | 194.18 |   | 137.82 |   | 181.13 |   |
| Non-interest income to average assets                            |   | 0.73                         |    | 0.74 |   | 1.30 |   | 1.44 |   | 1.83 |   |
| Non-interest expense to average assets                           |   | 2.94                         |    | 3.50 |   | 9.79 |   | 8.03 |   | 10.93 |   |
| Total loans receivable, net of fees to total deposits            |   | 70.87                        |    | 58.82 |   | 81.66 |   | 94.43 |   | 113.85 |   |
|                                                             |   |                         |    |   |   |   |   |   |   |   |   |
| **Asset Quality Ratios:**                                        |   |                         |    |   |   |   |   |   |   |   |   |
| Net charge-offs to average loans receivable                      |   | 0.01                         | %       | 0.05 | % | — | % | — | % | — | % |
| Non-performing loans to loans receivable, net of  fees           |   | 0.12                         |    | 0.39 |   | 0.46 |   | 0.38 |   | — |   |
| Non-performing loans to total assets                             |   | 0.06                         |    | 0.20 |   | 0.33 |   | 0.28 |   | — |   |
| Allowance for loan losses to nonperforming loans                 |   | 1,102.54                     |    | 345.49 |   | 334.84 |   | 323.68 |   | — |   |
| Allowance for loan losses to loan receivable, net  of fees       |   | 1.29                         |    | 1.35 |   | 1.54 |   | 1.23 |   | 1.07 |   |
|                                                             |   |                         |    |   |   |   |   |   |   |   |   |
| **Capital Ratios:**                                              |   |                         |    |   |   |   |   |   |   |   |   |
| Tier 1 risk-based capital                                        |   | 19.66                        | %       | 12.25 | % | 9.04 | % | 18.89 | % | 37.86 | % |
| Total risk-based capital                                         |   | 20.66                        |    | 13.35 |   | 10.42 |   | 19.94 |   | 38.75 |   |
| Leverage capital ratio                                           |   | 15.45                        |    | 8.97 |   | 8.57 |   | 17.39 |   | 32.55 |   |
|                                                             |   |                         |    |   |   |   |   |   |   |   |   |
| **Other:**                                                       |   |                         |    |   |   |   |   |   |   |   |   |
| Average shareholders’ equity to average total  assets       |   | 7.84                         | %       | 8.45 | % | 13.39 | % | 21.37 | % | 45.76 | % |
| Average loans receivable, net of fees to average  total deposits |   | 63.02                        |    | 59.36 |   | 91.69 |   | 97.03 |   | 92.07 |   |
| Average common shares outstanding:                               |   |                         |    |   |   |   |   |   |   |   |   |
| Basic                                                            |   | 10,218                       |    | 7,949 |   | 4,258 |   | 4,246 |   | 4,241 |   |
| Diluted                                                          |   | 10,445                       |    | 7,949 |   | 4,258 |   | 4,246 |   | 4,241 |   |

 

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(1)Net interest margin is calculated as net interest income divided by totalaverage earning assets.

(2)Efficiency ratio is calculated as total non-interest expense divided by thetotal of net interest income and non-interest income.

 

**Financial Overview**

** **

***2003 Compared to 2002***

** **

**At December 31, 2003, total assets were $636.2 million, anincrease of 30.8% or $149.9 million, compared to $486.3 million at December 31,2002.  Total loans receivable, net offees, increased 34.9% or $86.9 million, to $336.0 million at December 31, 2003,compared to $249.1 million at December 31, 2002.  Total investment securities increased by $109.9 million, or67.2%, to $273.6 million at**December 31, 2003, compared to $163.7 million at December 31,2002.  Total deposits increased 12.0%,or $50.7 million, to $474.1 million as of December 31,

 

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**2003, compared to $423.5 millionat December 31, 2002.  Otherborrowed funds increased $72.5 million to $74.5 million at December 31, 2003compared to $2.0 million at December 31, 2002. During 2003, we introduced repurchase agreements to our customers, whichtotaled $25.5 million at December 31, 2003. In addition, advances from the Federal Home Loan Bank of Atlantaincreased to $49.0 million as of December 31, 2003, due primarily to thisfunding source being at its lowest interest rates in several years.**

** **

Shareholders’equity at December 31, 2003 was $85.4 million, an increase of $44.7 million,compared to $40.7 million at December 31, 2002.  The increase in shareholders’ equity is primarily attributable toour completing a secondary common stock offering of 6.3 million shares thatraised $41.7 million in new capital during December 2003.  In addition, we issued another 945,000shares in January 2004, as a result of the exercise of the underwriters’over-allotment option, which provided us with an additional $6.7 million incapital.  This additional capital willbe used to support additional asset growth and general corporate purposes.  In addition, net income to common shareholdersof $5.7 million contributed to the increase in shareholders’ equity, offset bythe change in unrealized losses on investment securities available-for-sale of$2.9 million.  Book value per commonshare at December 31, 2003 and 2002 was $4.80 and $3.37, respectively.  Total risk based capital to totalrisk-weighted assets increased to 20.66% at December 31, 2003 compared to13.35% at December 31, 2002, maintaining a well-capitalized position forregulatory purposes going into 2004. Total shareholders’ equity to total assets at December 31, 2003 and 2002were 13.4% and 8.4%, respectively.

 

We recorded net income of $5.7 million, or $0.54 perdiluted common share, for the year ended December 31, 2003, compared to a netloss of $1.0 million or $0.13 per common share, for the comparable period in2002, an improvement of $6.7 million. This net income includes an income tax benefit of $3.5 millionattributable to the recognition of prior periods’ net operating losscarryforwards.  We recorded pretaxincome of $2.2 million for the year ended December 31, 2003.  All results are presented after the effectof preferred stock dividends of $495,000 for each of the years ended December31, 2003 and 2002.

 

The return on average assets was for the years endedDecember 31, 2003 and 2002 was 1.18% and (0.14)%, respectively.  The return on average equity for the yearsended December 31, 2003 and 2002 was 15.05% and (1.61)%, respectively.

##### ** **

##### ***2002 Comparedto 2001***

 

Our net loss for the year ended December 31, 2002 totaled $1.0 millionor $0.13 per common share, compared with a loss of $13.2 million or $3.11 percommon share for the same period of 2001. The 2002 loss included an other than temporary impairment of $1.7million of an investment in a WorldCom bond that we recorded in the secondquarter of 2002.  If the impact of theWorldCom impairment were excluded, we would have reported net income of$636,000, or $0.08 per common share, for the year ended December 31, 2002.  Table 1 shows a reconciliation of GAAP toNon-GAAP financial measures, which we believe appropriately compares ouroperating results for 2003, 2002 and 2001 by excluding the other than temporaryimpairment, goodwill impairment and restructuring costs reported in theirrespective periods.  All year-endresults are presented after the effect of dividends paid to preferredshareholders of $495,000 and $503,000 for the years ended December 31, 2002 and2001, respectively.  The return onaverage assets for the years ended December 31, 2002 and 2001 were (0.14)% and(5.24)%, respectively.  The return onaverage equity for the years ended December 31, 2002 and 2001 were (1.61)%and (39.14)%, respectively.

 

29

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Totalassets increased $206.7 million, or 74.0%, to $486.3 million at December 31,2002, compared to $279.6 million at December 31, 2001.  Asset growth was funded primarily by depositgrowth of $177.5 million, or 72.1%, to $423.5 million at December 31,2002.  The strong growth experiencedduring 2002 is attributed to aggressive promotion of our products throughadvertising and direct mail in addition to opening our eighth branch inArlington, Virginia during the fourth quarter of 2002.

 

Totalshareholders’ equity increased $20.1 million or 97.4% to $40.7 million atDecember 31, 2002 compared to $20.6 million at December 31, 2001.  This increase was primarily a result of the$18.5 million of additional capital that we raised in our two common stockofferings during the second quarter of 2002. Book value per common share increased to $3.37 at December 31, 2002compared to $3.21 at December 31, 2001. The ratio of risk-based capital to risk-based assets increased to 13.35%at December 31, 2002 compared to 10.42% at December 31, 2001.  Total shareholders’ equity to total assetsat December 31, 2002 and 2001 were 8.4% and 7.4%, respectively.

 

**Reconciliationof GAAP to Non-GAAP Financial Measures**Years ended December31, 2003, 2002 and 2001(Dollars in thousands, except per share data)

 
|                                                                          |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Reported net income (loss) to common shareholders                             |   | $        | 5,659  |     | $      | (1,024   | )      | $ | (13,227 | ) |
| Less impairments and restructuring costs:                                     |   |     |   |     |   |     |   |
| Other than temporary impairment of WorldCom bond                              |   | —   |   | 1,660    |   | —   |   |
| Impairment of Heritage Bancorp goodwill                                       |   | —   |   | —   |   | 8,264    |   |
| Restructuring costs                                                           |   | —   |   | —   |   | 884      |   |
| Net income (loss) without impairments and restructuring  costs                |   | $        | 5,659  |     | $      | 636      |   | $ | (4,079 | ) |
|                                                                          |   |     |   |     |   |     |   |
| Reported net income (loss) per common share                                   |   | $        | 0.55   |     | $      | (0.13    | )      | $ | (3.11 | ) |
| Less impairments and restructuring costs:                                     |   |     |   |     |   |     |   |
| Other than temporary impairment of WorldCom bond                              |   | —   |   | 0.21     |   | —   |   |
| Impairment of Heritage Bancorp goodwill                                       |   | —   |   | —   |   | 1.94     |   |
| Restructuring costs                                                           |   | —   |   | —   |   | 0.21     |   |
| Earnings (loss) per common share without  impairments and resturcturing costs |   | $        | 0.55   |     | $      | 0.08     |   | $ | (0.96 | ) |

 

##### **Statements of Operations**

 

*Net Interest Income/Margin*

 

Netinterest income is our primary source of revenue, representing the differencebetween interest and fees earned on interest-bearing assets and the interestpaid on deposits and other interest-bearing liabilities.  The level of net interest income is affectedprimarily by variations in the volume and mix of these assets and liabilities,as well as changes in interest rates when compared to previous periods.  During 2002 and continuing in 2003, wecontinued to experience a weakened economy that had entered into a recessionaryphase early in 2001.  During 2001, theFederal Reserve lowered rates eleven times in order to generate economicgrowth.  During the fourth quarter of2002, in response to this weakening economy and the lack of any inflationarypressures, the Federal Reserve lowered rates an additional 50 basispoints.  During the third quarter of2003, the Federal Reserve again decreased interest rates another 25 basispoints.  At 4.00%, the prime lendingrate is at its lowest levels in over forty years.

 

Netinterest income for the year ended December 31, 2003 was $15.2 million,compared to $10.7 million for the year ended December 31, 2002, an increase of$4.5 million, or 42.4%.  The increase innet interest income is a result of increases in average volume of investmentsecurities and loans receivable, net of the impact of decreased yields during2003, compared with the same period of 2002. These net increases were funded through the increases in total depositsand other borrowed funds.

 

Ournet interest margin for the years ended December 31, 2003 and 2002 was 3.00%and 2.92%, respectively.  The increasein the net interest margin was a result of the decrease in the cost of interestbearing liabilities offset slightly by the decrease in the yield onaverage earning assets. Theaverage yield on interest earning assets decreased to 4.86% in 2003 from 5.54%in 2002 and our cost of interest-bearing liabilities decreased to 2.31% in 2003from 3.27% in 2002.  The decrease in ourcost of interest-bearing deposits is primarily the result of our decreasing therate on our President’s Club relationship product to 1.51%, down from 2.00% atDecember 31, 2002.  In addition, theyield on other borrowed funds decreased 231 basis points to 1.68% at December31, 2003 compared to December 31, 2002.

 

30

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Totalearning assets increased by 37.0% to $616.7 million at December 31, 2003,compared to $450.3 million at December 31, 2002.  This increase consisted mainly of an $86.9 million, or 34.9%,increase in loans receivable, net of fees and a $109.9 million, or 67.2%,increase in total investment securities. These increases were funded by deposit growth of $50.7 million, or12.0%, and other borrowed funds growth of $72.5 million over December 31, 2002balances.  In addition, proceeds fromour secondary offering of $41.7 million funded our earning asset growth as ofDecember 31, 2003.

 

Averagetotal loans increased $66.1 million to $272.8 million during 2003 from $206.7million in 2002.  Average balances ofnonperforming assets, which consist of nonaccrual loans, are included in thenet interest margin calculation and did not have a material impact on our netinterest margin in 2003 and 2002. Additional interest income of approximately $39,000 for 2003 and $37,000for 2002 would have been realized had all nonperforming assets performed asoriginally expected.  Nonperformingassets exclude loans that are both past due 90 days or more and still accruinginterest due to an assessment of collectibility.

 

Averagetotal deposits increased $84.7 million to $432.8 million in 2003 from $348.1million in 2002.  The largest increasein average deposit balances was experienced in certificates of deposit, anincrease of $42.9 million compared to 2002, a result of our branch expansionand increased advertising of our rates on certificates of deposit.

 

Netinterest income was $10.7 million for the year ended December 31, 2002, up$1.6 million or 17.4% from 2001.  Theincrease was primarily due to the increase in loans and investment securitiesavailable-for-sale during 2002, funded through the increase in total depositsand shareholders’ equity.  The increasein net interest income was tempered by a reduction in our net interest margin,due primarily to yields on earning assets continuing to decline at a fasterpace than the decline in yields on interest bearing liabilities.

 

Thenet interest margin was 2.92% for the year ended December 31, 2002 compared to4.17% in 2001.  The decrease in the netinterest margin is representative of the change in the mix of earning assetstowards lower yielding investments and to the lower rate environmentexperienced during 2002.  The averageyield rate on interest earning assets decreased to 5.54% in 2002 from 7.61% in2001 and our average cost of interest-bearing liabilities decreased to 3.27% in2002 from 4.71% in 2001.

 

Totalearning assets increased by 70.5% to $450.3 million at December 31, 2002,compared to $264.1 million at December 31, 2001.  This increase consisted mainly of a $47.9 million, or 24.2%,increase in net loans receivable and a $129.5 million, or 379.3%, increase ininvestment securities available-for-sale. These increases were primarily funded by deposit growth of $177.5million, or 72.1%, over December 31, 2001 balances.

 

Averagetotal loans increased $25.6 million to $206.7 million during 2002 from $181.0million in 2001.  Average balances ofnonperforming assets, which consist of nonaccrual loans, are included in thenet interest margin calculation and did not have a material impact on our netinterest margin in 2002 and 2001. Additional interest income of approximately $37,000 for 2002 and $17,000for 2001 would have been realized had all nonperforming assets performed asoriginally expected.  Nonperformingassets exclude loans that are both past due 90 days or more and still accruinginterest due to an assessment of collectibility.

 

Averagetotal deposits increased $150.7 million to $348.1 million in 2002 from $197.4million in 2001.  The largest increasein average deposit balances was experienced in interest

 

31

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checking, an increase of $96.7million compared to 2001, as a result of our President’s Club relationshipaccount promotion.

 

The following tables contain more detailed information concerningaverage balances, yields earned, and rates paid.

 

**AverageBalance Sheets and Interest Rates on Earning Assets and Interest - BearingLiabilities**

Years Ended December 31,2003, 2002 and 2001

(Dollars in thousands)

 
|                                                     |   | **2003**             |    | **2002**                       |   | **2001** |   |
|----------------------------------------------------------|--------|----------------------|---------|--------------------------------|--------|----------|--------|
|                                                     |   | **Average  Balance** |    | **Interest  Income/  Expense** |   | **Rate** |   | **Average  Balance** |   | **Interest  Income/  Expense** |   | **Rate** |   | **Average  Balance** |   | **Interest  Income/  Expense** |   | **Rate** |   |
| **Assets**                                               |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                 |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1):                                               |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial and industrial                                |   | $                    | 50,188  |                           | $      | 3,101    |   | 6.18 | % | $ | 52,960 |   | $ | 3,696 |   | 6.98 | % | $ | 52,063 |   | $ | 4,407 |   | 8.46 | % |
| Real estate - commercial                                 |   | 121,345              |    | 8,422                          |   | 6.94     | %      | 91,289 |   | 7,276 |   | 7.97 | % | 72,500 |   | 6,288 |   | 8.67 | % |
| Real estate - construction                               |   | 20,427               |    | 1,131                          |   | 5.54     | %      | 6,156 |   | 375 |   | 6.09 | % | 5,634 |   | 487 |   | 8.64 | % |
| Real estate - residential                                |   | 38,059               |    | 2,414                          |   | 6.34     | %      | 20,139 |   | 1,534 |   | 7.62 | % | 17,972 |   | 1,501 |   | 8.35 | % |
| Home equity lines                                        |   | 33,720               |    | 1,121                          |   | 3.32     | %      | 23,711 |   | 993 |   | 4.19 | % | 18,023 |   | 1,146 |   | 6.36 | % |
| Consumer                                                 |   | 9,026                |    | 662                            |   | 7.33     | %      | 12,399 |   | 924 |   | 7.45 | % | 14,827 |   | 1,144 |   | 7.72 | % |
| Total loans                                              |   | 272,765              |    | 16,851                         |   | 6.18     | %      | 206,654 |   | 14,798 |   | 7.16 | % | 181,019 |   | 14,973 |   | 8.27 | % |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment securities  available-for-sale                |   | 152,915              |    | 5,026                          |   | 3.29     | %      | 101,589 |   | 4,501 |   | 4.43 | % | 7,022 |   | 437 |   | 6.22 | % |
| Investment securities  held-to-maturity                  |   | 67,685               |    | 2,483                          |   | 3.67     | %      | — |   | — |   | 0.00 | % | — |   | — |   | 0.00 | % |
| Other investments                                        |   | 2,906                |    | 135                            |   | 4.65     | %      | 1,253 |   | 72 |   | 5.75 | % | 1,373 |   | 82 |   | 5.97 | % |
| Federal funds sold                                       |   | 9,753                |    | 107                            |   | 1.10     | %      | 55,773 |   | 871 |   | 1.56 | % | 28,467 |   | 1,085 |   | 3.81 | % |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning  assets and interest income       |   | 506,024              |    | 24,602                         |   | 4.86     | %      | 365,269 |   | 20,242 |   | 5.54 | % | 217,881 |   | 16,577 |   | 7.61 | % |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-earning assets:                              |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                  |   | 10,291               |    |                           |   |     |   | 18,595 |   |   |   |   |   | 10,467 |   |   |   |   |   |
| Premises and equipment, net                              |   | 5,249                |    |                           |   |     |   | 4,820 |   |   |   |   |   | 5,579 |   |   |   |   |   |
| Goodwill and other  intangibles                          |   | 646                  |    |                           |   |     |   | 651 |   |   |   |   |   | 9,228 |   |   |   |   |   |
| Accrued interest and other  assets                       |   | 3,265                |    |                           |   |     |   | 2,551 |   |   |   |   |   | 1,695 |   |   |   |   |   |
| Allowance for loan losses                                |   | (3,652               | )       |                           |   |     |   | (3,060 | ) |   |   |   |   | (2,118 | ) |   |   |   |   |
| Total assets                                             |   | $                    | 521,823 |                           |   |     |   |   | $ | 388,826 |   |   |   |   |   | $ | 242,732 |   |   |   |   |   |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity**           |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest - bearing liabilities:                          |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest - bearing  deposits:                            |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest checking                                        |   | 147,746              |    | 2,375                          |   | 1.61     | %      | 114,350 |   | 3,073 |   | 2.69 | % | 17,675 |   | 370 |   | 2.09 | % |
| Money markets                                            |   | 26,722               |    | 208                            |   | 0.78     | %      | 28,667 |   | 525 |   | 1.83 | % | 25,346 |   | 767 |   | 3.03 | % |
| Statement savings                                        |   | 5,389                |    | 35                             |   | 0.65     | %      | 4,305 |   | 52 |   | 1.21 | % | 4,371 |   | 102 |   | 2.33 | % |
| Certificates of deposit                                  |   | 182,922              |    | 6,038                          |   | 3.30     | %      | 140,033 |   | 5,714 |   | 4.08 | % | 101,932 |   | 5,788 |   | 5.68 | % |
| Total interest - bearing  deposits                       |   | 362,779              |    | 8,656                          |   | 2.39     | %      | 287,355 |   | 9,364 |   | 3.26 | % | 149,324 |   | 7,027 |   | 4.71 | % |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed funds                                     |   | 46,069               |    | 773                            |   | 1.68     | %      | 5,564 |   | 222 |   | 3.99 | % | 10,002 |   | 473 |   | 4.73 | % |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing  liabilities and interest expense |   | 408,848              |    | 9,429                          |   | 2.31     | %      | 292,919 |   | 9,586 |   | 3.27 | % | 159,326 |   | 7,500 |   | 4.71 | % |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                        |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                          |   | 70,030               |    |                           |   |     |   | 60,786 |   |   |   |   |   | 48,110 |   |   |   |   |   |
| Other liabilities                                        |   | 2,043                |    |                           |   |     |   | 2,282 |   |   |   |   |   | 2,790 |   |   |   |   |   |
| Preferred shareholders’  equity                     |   | 6,824                |    |                           |   |     |   | 6,825 |   |   |   |   |   | 7,056 |   |   |   |   |   |
| Common shareholders’ equity                         |   | 34,078               |    |                           |   |     |   | 26,014 |   |   |   |   |   | 25,450 |   |   |   |   |   |
| Total liabilities and  shareholders’ equity         |   | $                    | 521,823 |                           |   |     |   |   | $ | 388,826 |   |   |   |   |   | $ | 242,732 |   |   |   |   |   |
|                                                     |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income and net  interest margin (2)         |   |                 |    | $                              | 15,173 |     | 3.00   | % |   |   | $ | 10,656 |   | 2.92 | % |   |   | $ | 9,077 |   | 4.17 | % |
|                                                          |        |                      |         |                                |        |          |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Non-accrual loans are included in average balances and do not have amaterial effect on the average yield. Interest income on non-accruing loans was not material for yearspresented.

(2)          We do not have investments that have tax benefit attributes; therefore,there are no tax equivalent adjustments to our net interest income.

 

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**Rate andVolume Analysis**

Years Ended December 31,2003, 2002 and 2001

(Dollars in thousands)

 
|                                      |   | **2003 Compared to 2002** |   | **2002 Compared to 2001** |   |
|-------------------------------------------|--------|---------------------------|--------|---------------------------|--------|
|                                      |   | **Change Due to**         |   |                      |   | **Change Due to** |   |   |   |
|                                      |   | **Average  Volume**       |   | **Average  Rate**         |   | **Increase  (Decrease)** |   | **Average  Volume** |   | **Average  Rate** |   | **Increase  (Decrease)** |   |
| **Interest  income:**                     |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Loans (1):                                |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Commercial and industrial                 |   | $                         | (193   | )                         | $      | (402 | ) | $ | (595 | ) | $ | 76 |   | $ | (787 | ) | $ | (711 | ) |
| Real estate - commercial                  |   | 2,396                     |   | (1,250                    | )      | 1,146 |   | 1,630 |   | (642 | ) | 988 |   |
| Real estate - construction                |   | 869                       |   | (113                      | )      | 756 |   | 45 |   | (157 | ) | (112 | ) |
| Real estate - residential                 |   | 1,365                     |   | (485                      | )      | 880 |   | 181 |   | (148 | ) | 33 |   |
| Home equity lines                         |   | 419                       |   | (291                      | )      | 128 |   | 362 |   | (515 | ) | (153 | ) |
| Consumer                                  |   | (251                      | )      | (11                       | )      | (262 | ) | (187 | ) | (33 | ) | (220 | ) |
| Total loans                               |   | 4,605                     |   | (2,552                    | )      | 2,053 |   | 2,107 |   | (2,282 | ) | (175 | ) |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Investment securities  available-for-sale |   | 2,274                     |   | (1,749                    | )      | 525 |   | 5,885 |   | (1,821 | ) | 4,064 |   |
| Investment securities  held-to-maturity   |   | 2,483                     |   | —                    |   | 2,483 |   | — |   | — |   | — |   |
| Other investments                         |   | 95                        |   | (32                       | )      | 63 |   | (7 | ) | (3 | ) | (10 | ) |
| Federal funds sold                        |   | (719                      | )      | (45                       | )      | (764 | ) | 1,041 |   | (1,255 | ) | (214 | ) |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Total interest income                     |   | 8,738                     |   | (4,378                    | )      | 4,360 |   | 9,026 |   | (5,361 | ) | 3,665 |   |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| **Interest  expense:**                    |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Interest - bearing  deposits:             |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Interest checking                         |   | 897                       |   | (1,595                    | )      | (698 | ) | 2,024 |   | 679 |   | 2,703 |   |
| Money markets                             |   | (36                       | )      | (281                      | )      | (317 | ) | 100 |   | (342 | ) | (242 | ) |
| Statement savings                         |   | 13                        |   | (30                       | )      | (17 | ) | (2 | ) | (48 | ) | (50 | ) |
| Certificates of deposit                   |   | 1,750                     |   | (1,426                    | )      | 324 |   | 2,163 |   | (2,237 | ) | (74 | ) |
| Total interest - bearing  deposits        |   | 2,624                     |   | (3,332                    | )      | (708 | ) | 4,285 |   | (1,948 | ) | 2,337 |   |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Other borrowed funds                      |   | 1,616                     |   | (1,065                    | )      | 551 |   | (210 | ) | (41 | ) | (251 | ) |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Total interest expense                    |   | 4,240                     |   | (4,397                    | )      | (157 | ) | 4,075 |   | (1,989 | ) | 2,086 |   |
|                                      |   |                      |   |                      |   |   |   |   |   |   |   |   |   |
| Net interest income (2)                   |   | $                         | 4,498  |                      | $      | 19 |   | $ | 4,517 |   | $ | 4,951 |   | $ | (3,372 | ) | $ | 1,579 |   |

 

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(1)          Non-accrual loans are included in average balances and do not have amaterial effect on the average yield. Interest income on non-accruing loans was not material for yearspresented.

(2)          Wedo not have investments that have tax benefit attributes; therefore, there areno tax equivalent adjustments to our net interest income.

 

33

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##### **Interest Rate Sensitivity**

##### ** **

Asset/liability managementinvolves monitoring our sensitivity to interest rate movements. In order tomeasure the effects of changes in interest rates on our net interest income, wetake into consideration the expected cash flows from the loan and investmentsecurities portfolios and the expected magnitude of the repricing of specificasset and liability categories. Management evaluates interest rate risk and then formulates guidelinesto manage this risk based upon its outlook regarding the economy, forecastedinterest rate movements and other business factors.  Management’s goal is to maximize and stabilize the net interestmargin by limiting exposure to interest rate changes.

 

Our Asset/LiabilityCommittee is responsible for reviewing our liquidity requirements andmaximizing our net interest income, consistent with capital requirements,liquidity, interest rate and economic outlooks, competitive factors andcustomer needs.  One of the tools we useto determine our interest rate risk is gap analysis.  Gap analysis attempts to examine the volume of interest ratesensitive assets less interest rate sensitive liabilities in various timeintervals.  The difference is theinterest sensitivity gap, which indicates how future changes in interest ratesmay affect net interest income. Interest sensitivity gap analysis presents a position that exists at oneparticular point in time and assumes that assets and liabilities with similarcharacteristics will re-price at the same time and to the same degree.  Under our asset/liability policies,regardless of whether interest rates are expected to increase or decrease, theobjective is to maintain a gap position that will minimize any changes in netinterest income.  A negative gap, orliability sensitive position, exists when we have more interest sensitiveliabilities maturing within a certain gap interval than interest sensitiveassets.  Under this scenario, ifinterest rates were to increase, it would tend to reduce interest income.

 

At December 31, 2003, wewere liability sensitive in the 2-90 day, 91-180 day, and 181-365 day gapintervals by –1.6%, -2.3% and –11.7%, respectively.  This is within our asset/liability management policy, whichindicates that we maintain an interest rate sensitivity position +/-15% tototal assets.  We can reprice ourinterest checking, savings, and money market accounts at any time.  We carefully analyze the impact of anydecrease in interest rates on our deposits, as we may experience a runoff indeposit balances as a result of such changes in interest rates.  Based on the degree and frequency ofmovement being limited in practice, we have classified 20% of these deposits inour immediate gap interval, 10% of these deposits in each of the gap intervalsfrom 2-90 days through the 1-3 year gap interval, leaving the remaining portionor 40% of these deposits in the over 3 year gap interval.  We continue to analyze the activity in ourdeposit portfolio and make changes in our gap assumptions as the activitydictates.

 

We also use a simulationprocess to measure interest rate risk and the impact of rate fluctuations onnet interest income.  These simulationsincorporate assumptions regarding balance sheet growth and mix, and there-pricing and maturity characteristics of existing and projected balancesheets.  One of the ways we manage ourinterest rate risk is through an analysis of the relationship betweeninterest-earning assets and interest-bearing liabilities to measure the impact

 

34

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that future changes in interest rates willhave on net interest income.  Using thisrelationship analysis, changes in interest rates and volumes are used to testthe sensitivity of our net interest income. While we show liability sensitivity in the short term indicating that anincrease in interest rates may negatively affect short-term net interestincome, we would likely take actions to minimize our exposure to negativeresults and within a short period of time make adjustments so that net interestincome would not be materially impacted.

 

During the past two years,our focus has been to increase our deposit market share through promotion ofour President’s Club and Totally Free Checking products.  The success of these promotions allowed usto grow our asset base 30.8% from December 31, 2002 to December 31, 2003and 74.0% from December 31, 2001 to December 31, 2002.  Our President’s Club relationship productallows customers with aggregate balances of over $10,000 to earn an abovemarket rate on their average balances, 1.51% as of December 31, 2003.  Because of the success of this promotion,our net interest margin has slightly increased during the year and averaged3.00% for the year ended December 31, 2003. Our current focus is to continue to improve our net interest margin bystaying fully invested, minimizing lower yielding short-term investments andusing our substantial mortgage-backed investment securities portfolio forbackup liquidity needs.

 

We expect our net interestincome will be greater over the longer term at higher prevailing interest ratelevels, although we may be negatively affected by rising rates in the shorterterm.  This is due to the largeproportion of low-cost core deposits such as demand, interest checking,savings, and money market accounts comprising our funding sources, which tendto be less sensitive to rising rates and can be invested in relatively higheryielding contradictory loans and investment securities.

 

**InterestRate Sensitivity Gap Analysis**

**At December31, 2003**

**(Dollars inthousands)**

 
|                                                                         |   | **Immediate  Repricing** |    | **2-90  Days** |   | **91-180  Days** |   | **181-365  Days** |    | **1-3  Years** |   | **Over 3  Years** |       | **TOTAL** |       |
|------------------------------------------------------------------------------|--------|--------------------------|---------|----------------|--------|------------------|--------|-------------------|---------|----------------|--------|-------------------|------------|-----------|------------|
| **Assets**                                                                   |   |                     |    |           |   |             |   |              |    |           |   |              |       |      |       |
| Total investment securities  and other investments                           |   | $                        | 1,247   |           | $      | 14,671           |   | $                 | 14,912  |           | $      | 18,758            |       | $         | 96,925     |   | $ | 130,618 |   | $ | 277,131 |   |
| Federal funds sold                                                           |   | 3,528                    |    | —         |   | —           |   | —            |    | —         |   | —            |       | 3,528     |       |
| **Loans  receivable, net of fees**                                           |   |                     |    |           |   |             |   |              |    |           |   |              |       |      |       |
| Commercial and industrial                                                    |   | 131,227                  |    | 3,216          |   | 3,991            |   | 7,337             |    | 21,542         |   | 30,085            |       | 197,398   |       |
| Residential                                                                  |   | 1,399                    |    | 398            |   | 1,231            |   | 4,152             |    | 8,029          |   | 27,286            |       | 42,495    |       |
| Home equity lines                                                            |   | 3,532                    |    | 33,720         |   | 5,115            |   | 809               |    | —         |   | —            |       | 43,176    |       |
| Construction                                                                 |   | 30,997                   |    | 2,241          |   | 3,471            |   | 996               |    | 4,538          |   | —            |       | 42,243    |       |
| Consumer                                                                     |   | 4,566                    |    | 534            |   | 182              |   | 430               |    | 729            |   | 4,249             |       | 10,690    |       |
| **Total  loans receivable, net of fees**                                     |   | 171,721                  |    | 40,109         |   | 13,990           |   | 13,724            |    | 34,838         |   | 61,620            |       | 336,002   |       |
| **Total  earning assets**                                                    |   | 176,496                  |    | 54,780         |   | 28,902           |   | 32,482            |    | 131,763        |   | 192,238           |       | 616,661   |       |
| **Cumulative  rate sensitive assets**                                        |   | $                        | 176,496 |           | $      | 231,276          |   | $                 | 260,178 |           | $      | 292,660           |       | $         | 424,423    |   | $ | 616,661 |   |   |   |
|                                                                         |   |                     |    |           |   |             |   |              |    |           |   |              |       |      |       |
| **Liabilities**                                                              |   |                     |    |           |   |             |   |              |    |           |   |              |       |      |       |
| **Deposits**                                                                 |   |                     |    |           |   |             |   |              |    |           |   |              |       |      |       |
| Noninterest-bearing demand                                                   |   | $                        | —  |           | $      | —           |   | $                 | —  |           | $      | —            |       | $         | —     |   | $ | 70,998 |   | $ | 70,998 |   |
| Interest-bearing  transaction accounts                                       |   | 36,559                   |    | 18,280         |   | 18,280           |   | 18,280            |    | 18,280         |   | 73,116            |       | 182,795   |       |
| Certificates of deposit -  fixed                                             |   | —                   |    | 7,739          |   | 12,731           |   | 24,731            |    | 52,390         |   | 12,933            |       | 110,524   |       |
| Certificates of deposit -  no penalty                                        |   | —                   |    | 27,533         |   | 11,869           |   | 51,785            |    | 18,625         |   | —            |       | 109,812   |       |
| **Total  Deposits**                                                          |   | 36,559                   |    | 53,552         |   | 42,880           |   | 94,796            |    | 89,295         |   | 157,047           |       | 474,129   |       |
| Other borrowed funds                                                         |   | 25,499                   |    | 11,625         |   | 625              |   | 12,250            |    | 13,249         |   | 11,209            |       | 74,457    |       |
| **Total deposits  and other borrowed funds**                                 |   | 62,058                   |    | 65,177         |   | 43,505           |   | 107,046           |    | 102,544        |   | 168,256           |       | 548,586   |       |
| **Cumulative  rate sensitive liabilities**                                   |   | $                        | 62,058  |           | $      | 127,235          |   | $                 | 170,740 |           | $      | 277,786           |       | $         | 380,330    |   | $ | 548,586 |   |   |   |
|                                                                         |   |                     |    |           |   |             |   |              |    |           |   |              |       |      |       |
| **Gap**                                                                      |   | $                        | 114,438 |           | $      | (10,397          | )      | $                 | (14,603 | )              | $      | (74,564           | )          | $         | 29,219     |   | $ | 23,982 |   |   |   |
| **Cumulative  gap**                                                          |   | 114,438                  |    | 104,041        |   | 89,438           |   | 14,874            |    | 44,093         |   | 68,075            |       |      |       |
| **Gap/ total  assets**                                                       |   | 17.99                    | %       | -1.63          | %      | -2.30            | %      | -11.72            | %       | 4.59           | %      | 3.77              | %          |      |       |
| **Cumulative  gap/ total assets**                                            |   | 17.99                    | %       | 16.35          | %      | 14.06            | %      | 2.34              | %       | 6.93           | %      | 10.70             | %          |      |       |
| **Rate  sensitive assets/ rate sensitive liabilities**                       |   | 2.84                     |    | 0.84           |   | 0.66             |   | 0.30              |    | 1.28           |   | 1.14              | ** ** |      | ** ** |
| **Cumulative  rate sensitive assets/ cumulative rate sensitive liabilities** |   | 2.84                     |    | 1.82           |   | 1.52             |   | 1.05              |    | 1.12           |   | 1.12              |       |      |       |
|                                                                              |        |                          |         |                |        |                  |        |                   |         |                |        |                   |            |           |            |  |  |  |  |  |  |  |  |

 

*Provision Expense and Allowance for Loan Losses*

 

Our policy is to maintainthe allowance for loan losses at a level that represents our best estimate ofknown and inherent losses in the loan portfolio.  Both the amount of the provision and the level of the allowancefor loan losses are impacted by many factors, including general economicconditions, actual and expected credit losses, historical trends and specificconditions of the individual borrower.

 

Provision for loan losseswas $1.0 million and $444,000 for the year ended December 31, 2003 and 2002,respectively.  The allowance for loanlosses at December 31, 2003 was $4.3 million compared to $3.4 million atDecember 31, 2002. Our allowance for loan loss ratio at December 31, 2003 was1.29% compared to 1.35% at December 31, 2002. The decrease in the allowance for loan loss ratio is primarilyreflective of the shift in the loan mix in our portfolio.  Our growth in the loan portfolio was mostlycomprised of increases in our residential and commercial real estate loans andhome equity loan portfolios, which require lower reserve coverage than otherportions of the loan portfolio.  Wecontinued to experience strong loan quality with annualized net charged-offloans equal to 0.01% to average loans receivable for the year ended December31, 2003, and non-performing loans equal to 0.12% of total loans as of December31, 2003.

 

Provision for loan losseswas $444,000 for 2002, compared to $1.2 million for 2001.  The growth in loans during 2002 wascomprised primarily of increases in our residential and home equity loanportfolios, which require lower reserve amounts than the remainder of the loanportfolio.

 

35

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The allowance for loanlosses increased to $3.4 million at December 31, 2002 from $3.1 million atDecember 31, 2001.  The ratio ofthe allowance for loan losses to total loans, net of fees, at December 31,2002 was 1.35% compared to 1.54% at December 31, 2001.  We experienced loan charge offs of $117,000for the year ended December 31, 2002 offset by recoveries of $15,000.  We had no charge offs prior to 2002.

 

See “Critical AccountingPolicies” found earlier in this discussion for more information on ourallowance for loan losses methodology.

 

The following tables containadditional information pertaining to the calculation and allocation of theallowance for loan losses by loan type and the percentage of the loan type tothe total loan portfolio.

 

 

**Allowancefor Loan Losses**

Years Ended December 31,2003, 2002, 2001, 2000 and 1999

(Dollars in thousands)

 
|                                                                          |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|-------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Beginning balance, January  1                                                 |   | $        | 3,372  |     | $      | 3,104    |   | $        | 1,900  |     | $      | 726 |   | $ | 212 |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Provision for loan losses                                                     |   | 1,001    |   | 444      |   | 1,202    |   | 753      |   | 514      |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Transfer to liability on  unfunded commitments                                |   | —   |   | (74      | )      | —   |   | —   |   | —   |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Assumed allowance for loan  losses from acquisition of Heritage Bancorp, Inc. |   | —   |   | —   |   | —   |   | 421      |   | —   |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Loans charged off:                                                            |   |     |   |     |   |     |   |     |   |     |   |
| Commercial and industrial                                                     |   | (74      | )      | (63      | )      | —   |   | —   |   | —   |   |
| Real estate - commercial                                                      |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate - construction                                                    |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate - residential                                                     |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Home equity lines                                                             |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Consumer                                                                      |   | (6       | )      | (54      | )      | —   |   | —   |   | —   |   |
| Total loans charged off                                                       |   | (80      | )      | (117     | )      | —   |   | —   |   | —   |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Recoveries:                                                                   |   |     |   |     |   |     |   |     |   |     |   |
| Commercial and industrial                                                     |   | 43       |   | 12       |   | 2        |   | —   |   | —   |   |
| Real estate - commercial                                                      |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate - construction                                                    |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate - residential                                                     |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Home equity lines                                                             |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Consumer                                                                      |   | 8        |   | 3        |   | —   |   | —   |   | —   |   |
| Total recoveries                                                              |   | 51       |   | 15       |   | 2        |   | —   |   | —   |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Net (charge offs)  recoveries                                                 |   | (29      | )      | (102     | )      | 2        |   | —   |   | —   |   |
|                                                                          |   |     |   |     |   |     |   |     |   |     |   |
| Ending balance, December  31,                                                 |   | $        | 4,344  |     | $      | 3,372    |   | $        | 3,104  |     | $      | 1,900 |   | $ | 726 |   |

 
|                                                        |   | **2003** |    | **2002** |   | **2001** |   | **2000** |    | **1999** |   |
|-------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|----------|---------|----------|--------|
| Loans:                                                      |   |     |    |     |   |     |   |     |    |     |   |
| Balance at year end                                         |   | $        | 336,002 |     | $      | 249,106  |   | $        | 200,911 |     | $      | 154,271 |   | $ | 68,167 |   |
| Allowance for loan losses  to loans receivable, net of fees |   | 1.29     | %       | 1.35     | %      | 1.54     | %      | 1.23     | %       | 1.07     | %      |
| Net charge-offs to average  loans receivable                |   | 0.01     | %       | 0.05     | %      | 0.00     | %      | 0.00     | %       | 0.00     | %      |
|                                                             |        |          |         |          |        |          |        |          |         |          |        |  |  |  |  |  |

 

36

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**Allocationof the Allowance for Loan Losses**

At December 31, 2003, 2002,2001, 2000 and 1999

(Dollars in thousands)

 
|                             |   | **2003**       |   | **2002**        |   | **2001**       |   |
|----------------------------------|--------|----------------|--------|-----------------|--------|----------------|--------|
|                             |   | **Allocation** |   | **% of Total*** |   | **Allocation** |   | **% of Total*** |   | **Allocation** |   | **% of Total*** |   |
| Commercial and industrial        |   | $              | 1,046  |            | 17.21  | %              | $      | 1,301 |   | 23.40 | % | $ | 1,149 |   | 28.71 | % |
| Real estate - commercial         |   | 1,662          |   | 41.56           | %      | 1,386          |   | 46.63 | % | 1,270 |   | 43.37 | % |
| Real estate - construction       |   | 497            |   | 12.57           | %      | 19             |   | 2.32 | % | 34 |   | 3.18 | % |
| Real estate - residential        |   | 418            |   | 12.64           | %      | 241            |   | 12.77 | % | 98 |   | 7.20 | % |
| Home equity lines                |   | 486            |   | 12.84           | %      | 201            |   | 10.77 | % | 176 |   | 10.60 | % |
| Consumer                         |   | 235            |   | 3.18            | %      | 224            |   | 4.11 | % | 377 |   | 6.94 | % |
|                             |   |           |   |            |   |           |   |   |   |   |   |   |   |
| Total allowance for loan  losses |   | $              | 4,344  |            | 100.00 | %              | $      | 3,372 |   | 100.00 | % | $ | 3,104 |   | 100.00 | % |

 
|                             |   | **2000**       |   | **1999**         |   |
|----------------------------------|--------|----------------|--------|------------------|--------|
|                             |   | **Allocation** |   | **% of  Total*** |   | **Allocation** |   | **% of  Total*** |   |
| Commercial                       |   | $              | 612    |             | 32.22  | % | $ | 241 |   | 33.10 | % |
| Real estate - commercial         |   | 678            |   | 37.05            | %      | 211 |   | 29.03 | % |
| Real estate - construction       |   | 50             |   | 2.65             | %      | 9 |   | 1.28 | % |
| Real estate - residential        |   | 181            |   | 11.51            | %      | 126 |   | 17.39 | % |
| Home equity lines                |   | 126            |   | 9.65             | %      | 40 |   | 5.54 | % |
| Consumer                         |   | 253            |   | 6.92             | %      | 99 |   | 13.66 | % |
|                             |   |           |   |             |   |   |   |   |   |
| Total allowance for loan  losses |   | $              | 1,900  |             | 100.00 | % | $ | 726 |   | 100.00 | % |

 

----

* Percentage of loan type to the total loan portfolio.

 

37

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*Non-Interest Income*

 

Non-interest income includesservices charges on deposits and loans, investment fee income and gains onsales of investment securities available-for-sale and continues to be animportant factor in our operating results. Non-interest income for the year ended December 31, 2003 and 2002 was$3.8 million and $2.9 million, respectively. The increase in non-interest income for the year ended December 31,2003, compared to the same period of 2002, is primarily the result of increasedsecurities gains related to sales of certain securities from the investmentsecurities available-for-sale portfolio. These gains were recorded on sales of mortgage-backed securities withaccelerated prepayment speeds, which were a result of the lower rateenvironment experienced during the past year. In addition, net gains on the sales of loans for the year ended December31, 2003, was $282,000 compared to $74,000 for the same period of 2002,representing an increase of $208,000. These gains were the result of sales of mortgage loans through a loansales program that began in March 2003. Offsetting the increases in securities gains and the loan sales gain wasa decrease of $155,000 in investment fee income for the year ended December 31,2003, compared to the same period in 2002. Investment fee income decreased in2003 compared to 2002 as a result of the conversion from Legg Mason, Inc. toRaymond James Financial Services, Inc., which caused a temporary decline intransaction activity during the second quarter of 2003.

 

Due to our increased numberof deposit accounts, service charges on deposit accounts increased $120,000 to$631,000 for the year ended December 31, 2003 compared to $511,000 for the yearended December 31, 2002.

 

Non-interest income was $2.9million for the year ended December 31, 2002 compared to $3.2 million for thesame period of 2001. Investment fee income decreased by $1.0 million to$940,000 for the year ended December 31, 2002, compared to $1.9 million in2001.  The decrease in investmentfee income during 2002 as compared to 2001 is a result of reduced transactionactivity and decreased assets under management experienced during 2002. Due to our increased number of depositaccounts, service charges on deposit accounts increased $113,000 to $511,000during 2002 as compared to $398,000 in 2001. We had net securities gains of $524,000 for the year ended December 31,2002 compared to none during 2001.

 

The following table providesadditional detail on non-interest income for the years ended December 31, 2003,2002, and 2001.

 

38

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**Non-InterestIncome**

Years Ended December 31,2003, 2002 and 2001

(Dollars in thousands)

 
|                                                           |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Service charges on deposit  accounts                           |   | $        | 631    |     | $      | 511      |   | $ | 398 |   |
| Loan service charges                                           |   | 382      |   | 392      |   | 433      |   |
| Investment fee income                                          |   | 785      |   | 940      |   | 1,941    |   |
| Net gain on sales of loans                                     |   | 282      |   | 74       |   | 49       |   |
| Net realized gain on  investment securities available-for-sale |   | 1,364    |   | 524      |   | —   |   |
| Net gain on sales of  assets                                   |   | —   |   | 39       |   | 18       |   |
| ATM transaction fees                                           |   | 107      |   | 100      |   | 92       |   |
| Credit card fees                                               |   | 46       |   | 46       |   | 39       |   |
| Check order fees                                               |   | 53       |   | 101      |   | 62       |   |
| Other income                                                   |   | 179      |   | 137      |   | 125      |   |
| **Total  non-interest income**                                 |   | $        | 3,829  |     | $      | 2,864    |   | $ | 3,157 |   |

 

*Non-Interest Expense*

 

Non-interest expenseincludes salaries and benefits, occupancy, professional fees anddepreciation.  Non-interest expense was$15.4 million and $13.6 million for the years ended December 31, 2003 and 2002,respectively, an increase of $1.8 million, or 12.9%.  The increase in non-interest expense for the year ended December31, 2003, compared to 2002, is primarily a result of the branch expansion thathas occurred over the past twelve months. We opened our eighth branch in Arlington during the fourth quarter of2002, our ninth branch in Tysons Corner during the third quarter of 2003, andour tenth and eleventh branches in Leesburg and Woodbridge during the fourthquarter of 2003.  Expenses related tothe branch expansion are represented in the increases in our salaries andbenefits expense and occupancy expense. Expenses have also increased in professional fees, marketing andadvertising, and loan expenses to support our branch openings and strong assetgrowth over the past year.  We expectnon-interest expense to continue to increase going forward as we continue ourbranch expansion in 2004.  We plan onopening our twelfth branch office in Herndon, Virginia in February 2004.

 

Non-interest expense was$13.6 million and $23.8 million for the years ended December 31, 2002 and 2001,respectively.  The decrease innon-interest expense of $10.2 million, or 42.7% for 2002 compared to 2001resulted mostly from a charge of $8.3 million during the fourth quarter of 2001that substantially eliminated the goodwill attributed to the purchase ofHeritage Bancorp, Inc.  Also, during2001, we made the decision to consolidate our four banks to one to simplify ourstructure and reduce costs. Consequently, included in non-interest expense for2001 is approximately $884,000 in non-recurring costs associated with therestructuring.

 

During the second quarter of2002, we recorded an other than temporary impairment of $1.7 million on aninvestment in a WorldCom bond. Excluding the effect of the previously mentioned impairment of goodwillassociated with the Heritage Bancorp acquisition and the $1.7 millionimpairment writedown of the WorldCom bond in 2002, total non-interest expense,which was $13.6 million and $23.8 million for the years ended December 31, 2002and 2001, respectively, under generally accepted accounting principles, wouldhave been $11.9 million and $15.5 million for the years ended December 31, 2002and 2001, respectively.  Thissubstantial decline of $3.6 million in non-interest expense was due primarilyto decreases in salaries and benefits expense, as well as discontinuation ofgoodwill amortization in 2002 due to the implementation of SFAS No. 142, *Goodwill and Other Intangible Assets*, andreflects tighter expense controls and improved efficiencies after theconsolidation from a multi-bank structure to a one-bank organization.

 

The following table reflectsthe components of non-interest expense for the years ended December 31, 2003,2002 and 2001.

 

**Non-InterestExpense**

Years Ended December 31,2003, 2002 and 2001

(Dollars in thousands)

 
|                                       |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Salary and benefits                        |   | $        | 6,726  |     | $      | 5,715    |   | $ | 7,731 |   |
| Occupancy                                  |   | 1,559    |   | 972      |   | 1,263    |   |
| Professional fees                          |   | 1,113    |   | 1,011    |   | 705      |   |
| Depreciation                               |   | 1,030    |   | 736      |   | 804      |   |
| Amortization and writedown  of intangibles |   | —   |   | 22       |   | 8,907    |   |
| Writedown on corporate  bond               |   | —   |   | 1,660    |   | —   |   |
| Data processing                            |   | 835      |   | 759      |   | 957      |   |
| Stationary and supplies                    |   | 387      |   | 317      |   | 306      |   |
| Brokerage clearing                         |   | 186      |   | 206      |   | 370      |   |
| Advertising and marketing                  |   | 913      |   | 541      |   | 368      |   |
| Telecommunications                         |   | 396      |   | 276      |   | 325      |   |
| Other taxes                                |   | 456      |   | 342      |   | 269      |   |
| Travel and entertainment                   |   | 148      |   | 127      |   | 164      |   |
| Bank operations                            |   | 569      |   | 411      |   | 875      |   |
| Premises and equipment                     |   | 351      |   | 271      |   | 247      |   |
| Miscellaneous                              |   | 686      |   | 239      |   | 465      |   |
| Total non-interest expense                 |   | $        | 15,355 |     | $      | 13,605   |   | $ | 23,756 |   |

 

39

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**IncomeTaxes**

 

We recorded an income tax benefit of $3.5 million inthe fourth quarter of 2003 attributable to the recognition of deferred taxassets related to the net operating loss carryforwards.  The benefit of our deferred tax asset wasrecognized based on a detailed assessment indicating that it is more likelythan not that the benefit of these net operating losses would be realized.  Factors that were considered in our decisionto record our income tax benefit were 2003 profitability, future projections ofcontinued profitability and the completion of our common stock offering inDecember 2003.  For more information,see “Critical Accounting Policies” earlier in this discussion. In addition,Footnote 9 to the Notes to Consolidated Financial Statements providesadditional information with respect to the deferred tax accounts and the netoperating loss carryforward.

 

##### **Statementsof Condition**

##### ** **

#### **Loans Receivable, Net**

#### ** **

We have detailed policiesand procedures that cover both commercial and consumer loan origination andmanagement of credit risk.  Loans areunderwritten in a manner that focuses on the borrower’s ability to repay.  Our goal is not to avoid risk, but to manageit and to include credit risk as part of the pricing decision for each product.

 

Total loans receivable, netof fees, were $336.0 million at December 31, 2003, an increase of $86.9million, or 34.9%, compared to December 31, 2002.  We achieved growth in all our loan categories with the exceptionof our commercial and industrial loans. Commercial and industrial loans decreased $438,000 as a result of experiencingmore loan payoffs than fundings in this loan category.  In 2002, we established a separate retaillending group, creating competitive home equity products.  In addition, we created a separatecommercial real estate lending group that has allowed us to increase our loanproduction in this portion of our loan portfolio.

 

Loans receivable accountedfor on a non-accrual basis at December 31, 2003 and December 31, 2002 were$390,000 and $917,000, respectively. Accruing loans, which are contractually past due 90 days or more as toprincipal or interest payments as of December 31, 2003 and December 31, 2002,were $4,000 and $59,000, respectively. There are no loans as of December 31, 2003 and December 31, 2002included above which are “troubled debt restructurings” as defined in SFAS No.15, *Accounting by Debtors and Creditors forTroubled Debt Restructurings.*

 

Interest income onnon-accrual loans, if recognized, is recorded using the cash basis method ofaccounting.  When a loan is placed onnon-accrual, unpaid interest is reversed against interest income if it wasaccrued in the current year and is charged to the allowance for loan losses ifit was accrued in prior years.  While onnon-accrual, the collection of interest is recorded as interest income onlyafter all principal has been collected. When all past contractual obligations are collected and, in our opinion,the borrower has demonstrated the ability to remain current, the loan isreturned to an accruing status.  Grossinterest income that would have been recorded if the nonaccrual loans had beencurrent with their original terms and had been outstanding throughout theperiod or since origination if held for part of the period for the years endedDecember 31, 2003 and 2002 were $39,000 and $37,000, respectively.  The interest income realized prior to theloans being placed on nonaccrual status for the years ended December 31, 2003and 2002 were $1,000 and $28,000, respectively.

 

Total loans receivable, netof fees, increased $48.2 million to $249.1 million at December 31, 2002,as compared to December 31, 2001.  Thestrongest growth was in commercial real estate loans and residential realestate loans.

 

40

----

 

Loans receivable accountedfor on a non-accrual basis at December 31, 2002 and 2001 were $917,000 and$361,000, respectively.  Accruing loans,which are contractually past due 90 days or more as to principal or interestpayments as of December 31, 2002 and 2001, were $59,000 and $566,000, respectively.  There are no loans as of December 31, 2002and 2001 included above which are “troubled debt restructurings” as defined inSFAS No. 15, *Accounting by Debtors andCreditors for Troubled Debt Restructurings.*  Gross interest income that would have beenrecorded if the nonaccrual loans had been current with their original terms andhad been outstanding throughout the period or since origination if held forpart of the period for 2002 and 2001 was $37,000 and $17,000, respectively.  The interest income realized prior to theloans being placed on nonaccrual status for 2002 was $28,000.

 

Specific reserves of $21,500were recorded in 2002 for one of the non-accrual loans.  At December 31, 2002 the ratio ofnon-performing loans to total loans was 0.39% as compared to 0.46% at December31, 2001.

 

The following tablesrepresent the characteristics of our loans receivable portfolio as of December31, 2003, 2002, 2001, 2000 and 1999, additional information on nonperformingloans receivable, and information on loan maturities and interest ratesensitivity.

 

**LoansReceivable**

At December 31, 2003, 2002,2001, 2000 and 1999

(Dollars in thousands)

 
|                             |   | **2003** |    | **2002** |   | **2001** |   |
|----------------------------------|--------|----------|---------|----------|--------|----------|--------|
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Commercial and industrial        |   | $        | 57,854  |     | 17.21  | %        | $      | 58,292 |   | 23.40 | % | $ | 57,665 |   | 28.71 | % |
| Real estate - commercial         |   | 139,725  |    | 41.56    | %      | 116,135  |   | 46.63 | % | 87,116 |   | 43.37 | % |
| Real estate - construction       |   | 42,243   |    | 12.57    | %      | 5,781    |   | 2.32 | % | 6,397 |   | 3.18 | % |
| Real estate - residential        |   | 42,495   |    | 12.64    | %      | 31,808   |   | 12.77 | % | 14,469 |   | 7.20 | % |
| Home equity lines                |   | 43,176   |    | 12.84    | %      | 26,831   |   | 10.77 | % | 21,299 |   | 10.60 | % |
| Consumer                         |   | 10,690   |    | 3.18     | %      | 10,235   |   | 4.11 | % | 13,941 |   | 6.94 | % |
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Gross loans                      |   | $        | 336,183 |     | 100.00 | %        | $      | 249,082 |   | 100.00 | % | $ | 200,887 |   | 100.00 | % |
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Add: net deferred (fees) costs   |   | (181     | )       |     |   | 24       |   |   |   | 24 |   |   |   |
| Less: allowance for loan  losses |   | (4,344   | )       |     |   | (3,372   | )      |   |   | (3,104 | ) |   |   |
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Loans receivable, net            |   | $        | 331,658 |     |   |     | $      | 245,734 |   |   |   | $ | 197,807 |   |   |   |

 
|                             |   | **2000** |    | **1999** |   |
|----------------------------------|--------|----------|---------|----------|--------|
|                             |   |     |    |     |   |   |   |   |   |
| Commercial and industrial        |   | $        | 49,646  |     | 32.22  | % | $ | 22,558 |   | 33.10 | % |
| Real estate - commercial         |   | 57,083   |    | 37.05    | %      | 19,780 |   | 29.03 | % |
| Real estate - construction       |   | 4,088    |    | 2.65     | %      | 870 |   | 1.28 | % |
| Real estate - residential        |   | 17,729   |    | 11.51    | %      | 11,851 |   | 17.39 | % |
| Home equity lines                |   | 14,867   |    | 9.65     | %      | 3,777 |   | 5.54 | % |
| Consumer                         |   | 10,665   |    | 6.92     | %      | 9,311 |   | 13.66 | % |
|                             |   |     |    |     |   |   |   |   |   |
| Gross loans                      |   | $        | 154,078 |     | 100.00 | % | $ | 68,147 |   | 100.00 | % |
|                             |   |     |    |     |   |   |   |   |   |
| Add: net deferred (fees)  costs  |   | 193      |    |     |   | 20 |   |   |   |
| Less: allowance for loan  losses |   | (1,900   | )       |     |   | (726 | ) |   |   |
|                             |   |     |    |     |   |   |   |   |   |
| Loans receivable, net            |   | $        | 152,371 |     |   |   | $ | 67,441 |   |   |   |

 

41

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**NonperformingLoans Receivable**

At December 31, 2003, 2002,2001, 2000, and 1999

(Dollars in thousands)

 
|                                          |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Nonaccruing loans                             |   | $        | 390    |     | $      | 917      |   | $        | 361    |     | $      | 585 |   | $ | — |   |
|                                          |   |     |   |     |   |     |   |     |   |     |   |
| Loans contractually  past-due 90 days or more |   | 4        |   | 59       |   | 566      |   | 2        |   | —   |   |
|                                          |   |     |   |     |   |     |   |     |   |     |   |
| Troubled debt  restructurings                 |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Total nonperforming loans  receivable         |   | $        | 394    |     | $      | 976      |   | $        | 927    |     | $      | 587 |   | $ | — |   |

** **

**LoanMaturities and Interest Rate Sensitivity**

At December 31, 2003

(Dollars in thousands)

 
|                        |   | **One Year  or Less** |    | **Between  One and  Five Years** |   | **After  Five Years** |   | **Total** |   |
|-----------------------------|--------|-----------------------|---------|----------------------------------|--------|-----------------------|--------|-----------|--------|
| Commercial and industrial   |   | $                     | 145,776 |                             | $      | 21,542                |   | $         | 30,080 |   | $ | 197,398 |   |
| Residential                 |   | 7,176                 |    | 16,187                           |   | 19,132                |   | 42,495    |   |
| Home equity lines           |   | 43,176                |    | —                           |   | —                |   | 43,176    |   |
| Construction                |   | 37,704                |    | 4,539                            |   | —                |   | 42,243    |   |
| Consumer                    |   | 5,712                 |    | 801                              |   | 4,177                 |   | 10,690    |   |
| **Total  loans receivable** |   | $                     | 239,544 |                             | $      | 43,069                |   | $         | 53,389 |   | $ | 336,002 |   |
|                        |   |                  |    |                             |   |                  |   |      |   |
| Fixed - rate loans          |   |                  |    | $                                | 32,943 |                  | $      | 51,900    |   | $ | 84,843 |   |
| Floating - rate loans       |   |                  |    | 10,126                           |   | 1,489                 |   | 11,615    |   |
| **Total  loans receivable** |   |                  |    | $                                | 43,069 |                  | $      | 53,389    |   | $ | 96,458 |   |

 

#### **Investment Securities**

#### ** **

Our investment securitiesportfolio is used as a source of income and liquidity.  Investment securities were $273.6 million atDecember 31, 2003, an increase of $109.9 million or 67.2%, compared toinvestment securities at December 31, 2002. Increases in the investment securities portfolio were a result of thestrong deposit growth and increases in other borrowed funds.

 

During the third quarter of2003, we transferred a portion of the available-for-sale investment securitiesportfolio to held-to-maturity.  Thesesecurities are mostly pledged as collateral for Federal Home Loan Bank advancesand our customer repurchase agreements. Of the $273.6 million investment portfolio, $142.9 million areclassified as held-to-maturity and $130.8 million are classified as available-for-sale.  We had no held-to-maturity investmentsecurities at December 31, 2002 and 2001.

 

During the third quarter of 2003,we implemented a $25.0 million leverage strategy that allowed us to takeadvantage of the availability of low cost funds through advances from theFederal Home Loan Bank of Atlanta and purchase mortgage-backed investmentsecurities.  The impact of this strategyis an increase of approximately $100,000 in net interest income on a quarterlybasis.

 

Investment securitiesavailable-for-sale increased to $163.7 million at December 31, 2002, comparedto $34.1 million at December 31, 2001. Strong deposit growth and the proceeds of our two common stock offeringsduring 2002 made more funds available for investments.  The portfolio yield decreased from 6.22% asof December 31, 2001 to 4.43% as of December 31, 2002 due to higher yieldinginvestments having matured, been called or sold for a net realized gain andpurchases of additional investments during 2002 yielding lower rates. Duringthe second quarter of 2002, we experienced an impairment on an investment in aWorldCom bond that resulted in a charge to non-interest expense of $1.7million.

 

42

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The following table reflectsthe composition of the investment portfolio as of December 31, 2003, 2002, and2001.

 

**Investment Securities**

AtDecember 31, 2003, 2002 and 2001

(Dollarsin thousands)

 
|                                                               |   | **Amortized  Cost** |       | **Fair  Value** |       | **Average  Yield** |       |
|--------------------------------------------------------------------|--------|---------------------|------------|-----------------|------------|--------------------|------------|
| **Available-for-sale  at December 31, 2003**                       |   |                | ** ** |            | ** ** |               | ** ** |
| Obligations of U.S.  government-sponsored agencies and enterprises |   |                |       |            |       |               |       |
| One to five years                                                  |   | $                   | 3,000      |            | $          | 3,016              |       | 3.92 | % |
| Five to ten years                                                  |   | 2,000               |       | 1,986           |       | 4.23               | %          |
| After ten years                                                    |   | 1,000               |       | 1,027           |       | 5.79               | %          |
| Total U.S.  government-sponsored agencies                          |   | $                   | 6,000      |            | $          | 6,029              |       | 4.33 | % |
|                                                               |   |                |       |            |       |               |       |
| Mortgage-backed  securities*                                       |   |                |       |            |       |               |       |
| Five to ten years                                                  |   | $                   | 15,615     |            | $          | 15,630             |       | 3.92 | % |
| After ten years                                                    |   | 97,865              |       | 97,041          |       | 4.02               | %          |
| Total mortgage-backed  securities                                  |   | $                   | 113,480    |            | $          | 112,671            |       | 4.00 | % |
|                                                               |   |                |       |            |       |               |       |
| Corporate bonds                                                    |   |                |       |            |       |               |       |
| After ten years                                                    |   | $                   | 10,000     |            | $          | 9,995              |       | 2.41 | % |
| Total corporate bonds                                              |   | $                   | 10,000     |            | $          | 9,995              |       | 2.41 | % |
|                                                               |   |                |       |            |       |               |       |
| Treasury bonds                                                     |   |                |       |            |       |               |       |
| One to five years                                                  |   | $                   | 2,047      |            | $          | 2,067              |       | 2.64 | % |
| Total treasury bonds                                               |   | $                   | 2,047      |            | $          | 2,067              |       | 2.64 | % |
| Total investment  securities available-for-sale                    |   | $                   | 131,527    |            | $          | 130,762            |       | 3.87 | % |

 
|                                                               |   | **Amortized  Cost** |    | **Fair  Value** |   | **Average  Yield** |   |
|--------------------------------------------------------------------|--------|---------------------|---------|-----------------|--------|--------------------|--------|
| **Held-to-maturity  at December 31, 2003**                         |   |                |    |            |   |               |   |
| Obligations of U.S.  government-sponsored agencies and enterprises |   |                |    |            |   |               |   |
| One to five years                                                  |   | $                   | 4,000   |            | $      | 3,951              |   | 3.39 | % |
| Five to ten years                                                  |   | 9,993               |    | 9,884           |   | 4.65               | %      |
| After ten years                                                    |   | 2,999               |    | 2,950           |   | 4.20               | %      |
| Total U.S.  government-sponsored agencies                          |   | $                   | 16,992  |            | $      | 16,785             |   | 4.27 | % |
|                                                               |   |                |    |            |   |               |   |
| Mortgage-backed  securities*                                       |   |                |    |            |   |               |   |
| Five to ten years                                                  |   | $                   | 9,476   |            | $      | 9,450              |   | 3.70 | % |
| After ten years                                                    |   | 108,384             |    | 107,547         |   | 4.01               | %      |
| Total mortgage-backed  securities                                  |   | $                   | 117,860 |            | $      | 116,997            |   | 3.98 | % |
|                                                               |   |                |    |            |   |               |   |
| Corporate bonds                                                    |   |                |    |            |   |               |   |
| After ten years                                                    |   | $                   | 8,000   |            | $      | 7,848              |   | 4.21 | % |
| Total corporate bonds                                              |   | $                   | 8,000   |            | $      | 7,848              |   | 4.21 | % |
| Total investment securities  held-to-maturity                      |   | $                   | 142,852 |            | $      | 141,630            |   | 4.03 | % |
|                                                               |   |                |    |            |   |               |   |
| Total investment  securities                                       |   | $                   | 274,379 |            | $      | 272,392            |   | 3.96 | % |

 

43

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|                                                               |   | **Amortized  Cost** |       | **Fair  Value** |       | **Average  Yield** |       |
|--------------------------------------------------------------------|--------|---------------------|------------|-----------------|------------|--------------------|------------|
| **Available-for-sale  at December 31, 2002**                       |   |                | ** ** |            | ** ** |               | ** ** |
| Obligations of U.S.  government-sponsored agencies and enterprises |   |                |       |            |       |               |       |
| One to five years                                                  |   | $                   | 26,739     |            | $          | 26,988             |       | 3.47 | % |
| Five to ten years                                                  |   | 12,048              |       | 12,048          |       | 3.68               | %          |
| Total U.S.  government-sponsored agencies                          |   | $                   | 38,787     |            | $          | 39,036             |       | 3.53 | % |
|                                                               |   |                |       |            |       |               |       |
| Mortgage-backed  securities*                                       |   |                |       |            |       |               |       |
| Within one year                                                    |   | $                   | 15,478     |            | $          | 15,750             |       | 3.61 | % |
| One to five years                                                  |   | 70,552              |       | 72,342          |       | 4.82               | %          |
| Five to ten years                                                  |   | 13,695              |       | 13,686          |       | 4.43               | %          |
| After ten years                                                    |   | 15,301              |       | 15,301          |       | 5.20               | %          |
| Total mortgage-backed  securities                                  |   | $                   | 115,026    |            | $          | 117,079            |       | 4.66 | % |
|                                                               |   |                |       |            |       |               |       |
| Corporate bonds                                                    |   |                |       |            |       |               |       |
| After ten years                                                    |   | $                   | 5,000      |            | $          | 5,000              |       | 3.39 | % |
| Total corporate bonds                                              |   | $                   | 5,000      |            | $          | 5,000              |       | 3.39 | % |
|                                                               |   |                |       |            |       |               |       |
| Treasury bonds                                                     |   |                |       |            |       |               |       |
| One to five years                                                  |   | $                   | 2,507      |            | $          | 2,550              |       | 2.67 | % |
| Total treasury bonds                                               |   | $                   | 2,507      |            | $          | 2,550              |       | 2.67 | % |
|                                                               |   |                |       |            |       |               |       |
| Total investment  securities available-for-sale                    |   | $                   | 161,320    |            | $          | 163,665            |       | 4.33 | % |

 
|                                                              |   | **Amortized  Cost** |       | **Fair  Value** |       | **Average  Yield** |       |
|-------------------------------------------------------------------|--------|---------------------|------------|-----------------|------------|--------------------|------------|
| **Available-for-sale at December 31, 2001**                       |   |                | ** ** |            | ** ** |               | ** ** |
| Obligations of U.S. government-sponsored agencies and enterprises |   |                |       |            |       |               |       |
| One to five years                                                 |   | $                   | 2,985      |            | $          | 2,950              |       | 4.15 | % |
| Five to ten years                                                 |   | 1,516               |       | 1,508           |       | 4.67               | %          |
| Total U.S.  government-sponsored agencies                         |   | $                   | 4,501      |            | $          | 4,458              |       | 4.32 | % |
|                                                              |   |                |       |            |       |               |       |
| Mortgage-backed securities*                                       |   |                |       |            |       |               |       |
| Within one year                                                   |   | $                   | 182        |            | $          | 183                |       | 2.55 | % |
| One to five years                                                 |   | 11,456              |       | 11,383          |       | 5.22               | %          |
| Five to ten years                                                 |   | 5,927               |       | 5,865           |       | 5.79               | %          |
| After ten years                                                   |   | 4,965               |       | 4,926           |       | 5.96               | %          |
| Total mortgage-backed  securities                                 |   | $                   | 22,530     |            | $          | 22,357             |       | 5.51 | % |
|                                                              |   |                |       |            |       |               |       |
| Corporate bonds                                                   |   |                |       |            |       |               |       |
| One to five years                                                 |   | $                   | 6,154      |            | $          | 6,114              |       | 5.42 | % |
| Five to ten years                                                 |   | 986                 |       | 969             |       | 6.98               | %          |
| Total corporate bonds                                             |   | $                   | 7,140      |            | $          | 7,083              |       | 5.64 | % |
|                                                              |   |                |       |            |       |               |       |
| Treasury bonds                                                    |   |                |       |            |       |               |       |
| One to five years                                                 |   | $                   | 250        |            | $          | 249                |       | 1.87 | % |
| Total treasury bonds                                              |   | $                   | 250        |            | $          | 249                |       | 1.87 | % |
|                                                              |   |                |       |            |       |               |       |
| Total investment  securities available-for-sale                   |   | $                   | 34,421     |            | $          | 34,147             |       | 5.36 | % |

 

----

* Based on contractual maturities.

 

44

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**Depositsand Other Borrowed Funds**

 

Total deposits were $474.1million at December 31, 2003, an increase of $50.7 million, or 12.0%, comparedto December 31, 2002.  This growth isattributable to aggressive promotion of our products through advertising anddirect mail in addition to three branch openings during 2003.

 

Other borrowed funds were$74.5 million at December 31, 2003, an increase of $72.5 million, compared toDecember 31, 2002.  During the secondquarter of 2003, we introduced a repurchase agreement program for thosecommercial customers that leave larger balances in their demand depositaccounts, allowing them to earn 0.75% on balances deposited in thisprogram.  Repurchase agreements atDecember 31, 2003 were $25.5 million. These funds were invested in investment securities, allowing us toincrease our net interest income and improve our interest rate sensitivityposition.

 

The remaining portion ofother borrowed funds at December 31, 2003, were advances from the Federal HomeLoan Bank of Atlanta.  Due to interest rateson these advances being at their lowest levels in several years, we borrowed$47.0 million during the year ended December 31, 2003.  These advances bear fixed interest ratesranging from 1.23% to 2.81% and have scheduled maturities from January 20, 2004through July 14, 2008.

 

The following table reflectsthe short-term borrowings outstanding as of December 31, 2003.

 

**Short-Term Borrowings**

AtDecember 31, 2003

(Dollarsin thousands)

 
| **Advance  Date** |   | **Interest  Rate** |   | **Term of  Advance** |   | **Date  Amount  Due**      |   | **Outstanding** |   |
|-------------------|--------|--------------------|--------|----------------------|--------|----------------------------|--------|-----------------|--------|
| Jan-03            |   | 1.63               | %      | 12 months            |   | Jan-04                     |   | $               | 2,000  |   |
| Jan-03            |   | 1.72               | %      | 12 months            |   | Jan-04                     |   | 2,000           |   |
| Mar-03            |   | 1.54               | %      | 12 months            |   | Mar-04                     |   | 1,000           |   |
| Mar-03            |   | 1.65               | %      | 12 months            |   | Mar-04                     |   | 2,000           |   |
| Aug-03            |   | 1.31               | %      | 5 months             |   | Jan-04                     |   | 2,000           |   |
| Aug-03            |   | 1.36               | %      | 6 months             |   | Feb-04                     |   | 2,000           |   |
| Dec-03            |   | 1.23               | %      | 12 months            |   | Dec-04                     |   | 5,000           |   |
|              |   | 1.44               | %      |                 |   |                       |   | $               | 16,000 |   |
|              |   |               |   |                 |   | All other borrowed funds   |   | 58,457          |   |
|              |   |               |   |                 |   | Total other borrowed funds |   | $               | 74,457 |   |

 

Total deposits at December 31, 2002 were $423.5 million compared to $246.0million at December 31, 2001, an increase of $177.5 million, or 72.1%.  Other borrowed funds decreased $7.8 millionto $2.0 million at December 31, 2002, compared to $9.8 million at December 31,2001.  During 2002, we paid off $7.8million in Federal Home Loan Bank advances due to increased liquidity fromdeposit growth.

 

The following table reflectsthe maturities of the certificates of deposit of $100,000 or more as ofDecember 31, 2003, 2002 and 2001.

 

**Certificates of Deposit of $100,000 or More**

AtDecember 31, 2003, 2002 and 2001

(Dollarsin thousands)

 
|                                   |   | **2003** |    | **2002** |   | **2001** |   |
|----------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| **Maturities:**                        |   |     |    |     |   |     |   |
| Three months or less                   |   | $        | 19,467  |     | $      | 10,759   |   | $ | 9,531 |   |
| Over three months through  six months  |   | 11,463   |    | 8,716    |   | 8,046    |   |
| Over six months through  twelve months |   | 38,107   |    | 15,523   |   | 16,855   |   |
| Over twelve months                     |   | 34,563   |    | 45,214   |   | 25,349   |   |
|                                   |   | $        | 103,600 |     | $      | 80,212   |   | $ | 59,781 |   |

 

45

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**Business Segment Operations**

 

We provide banking andnon-banking financial services and products through our subsidiaries.  Management operates and reports on theresults of our operations through two business segments, commercial banking andinvestment services.

 

*Commercial Banking*

 

**The commercial banking segmentprovides a wide range of banking services to small businesses and individualsthrough multiple delivery channels. Services offered include commercial and consumer lending, depositproducts, and banking via the internet or telephone.**

** **

For the year ended December31, 2003, the commercial banking segment recorded net income of $4.2 million,compared to a loss of $16,000 during the same period of 2002, an improvement of$4.2 million.  The improvement inearnings is a result of increased net interest income, due to increased volumeof earning assets, as well as an increase in non-interest income due torealized gains on investment securities available-for-sale, for thissegment.  In addition, the writedown ofthe bond impairment was recognized in this business segment during the secondquarter of 2002.  Also, a portion of theincome tax benefit of $464,000 was recorded in this segment during the fourthquarter of 2003.

 

As of December 31, 2003,total assets were $630.4 million, loans receivable, net $331.7 million andtotal deposits were $474.1 million.  Asof December 31, 2002, total assets were $483.1 million, loans receivable, netwere $245.7 million and total deposits were $423.5 million.

 

**For the year ended December 31,2002, the commercial banking segment had a net loss of $16,000, compared to anet loss of $10.2 million for the year ended December 31, 2001.  The decrease in the net loss for 2002 is aresult of increased earning assets and lower operating expenses.  The results for 2001 included both theamortization and impairment recognition in goodwill, while the results for 2002did not include goodwill.  Net interestincome, as our primary source of revenue, for the years ended December 31, 2002and 2001 were $10.6 million and $9.1 million, respectively.**

** **

**As of December 31, 2002 and 2001,total assets were $483.1 million and $277.9 million, respectively.  Loans receivable, net as of December 31,2002 and 2001 were $245.7 million and $197.8 million, respectively.  Total deposits as of December 31, 2002 and2001 were $423.5 million and $246.0 million, respectively.**

** **

*Investment Services*

 

**The investment services segmentprovides investment and financial services, through an affiliation with a thirdparty broker-dealer.  Operations forthis segment began February 1, 1999.**

** **

For the year ended December31, 2003, this segment reported a net income of $466,000, compared to a netloss of $205,000 for the same period of 2002, an improvement of $671,000.  The increase in net income is mostlyattributable to the income tax benefit of $443,000 recorded in this segmentduring the fourth quarter of 2003. Pretax income for year ended December 31, 2003 was $23,000.  As of December 31, 2003, total assets were$776,000 and, at December 31, 2002, were $274,000.

 

For the years ended December 31, 2002 and 2001, theinvestment services segment reported net losses of $205,000 and $87,000,respectively.  Investment fee income, asthe primary source of revenue for this reporting segment, for the years endedDecember 31, 2002 and 2001 were $942,000 and $1.9 million, respectively.  Investment fee income decreased during 2002as compared to prior periods as a result of reduced transaction activity anddecreased assets under management experienced during 2002.  As ofDecember 31, 2002 and 2001, total assets were $274,000 and $420,000,respectively.

 

46

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Information pertaining toboth business segments can be found in Footnote 15 to the Notes to ConsolidatedFinancial Statements.

 

**CapitalResources**

 

Capital adequacy is animportant measure of financial stability and performance.  Our objectives are to maintain a level ofcapitalization that is sufficient to sustain asset growth and promote depositorand investor confidence.

 

Regulatory agencies measurecapital adequacy utilizing a formula that takes into account the individualrisk profile of a financial institution. The guidelines define capital as both Tier 1 (primarily commonshareholders’ equity, defined to include certain debt obligations) and Tier 2(to include certain other debt obligations and a portion of the allowance forloan losses and 45% of unrealized gains in equity securities).

 

At December 31, 2003, shareholders’equity was $85.4 million compared to $40.7 million at December 31, 2002, anincrease of $44.7 million.  Thisincrease in shareholders’ equity was primarily driven by our completion of asecondary common stock offering that raised $41.7 million in capital inDecember 2003.  In addition, we recordednet income to common shareholders of $5.7 million for the year ended December31, 2003.  These increases were offsetby an unfavorable mark-to-market adjustment of $2.9 million in our investmentsecurities available-for-sale portfolio. Book value per common share atDecember 31, 2003 was $4.80, compared to $3.37 at December 31, 2002.  Tangible book value per common share atDecember 31, 2003 was $4.80, compared to $3.31 at December 31, 2002.  At December 31, 2003, our tier 1 and totalrisk-based capital ratios were 19.7% and 20.7%, respectively.  At December 31, 2002, our tier 1 and totalrisk-based capital ratios were 12.3% and 13.4%, respectively.  Our regulatory capital levels for the bankand bank holding company exceed the minimum ratios established for well-capitalizedinstitutions.

 

At December 31, 2002,shareholders’ equity was $40.7 million compared to $20.6 million at December31, 2001.  The increase in shareholders’equity is the result of our second quarter 2002 rights and secondary commonstock offerings, which raised $18.5 million in new capital.  In addition, changes in unrealized gains oninvestment securities available-for-sale amounted to $2.6 million for the yearended December 31, 2002.  The increasesin common stock and other comprehensive income offset the preferred dividendspaid and the net loss for 2002.  Bookvalue per common share as December 31, 2002 and 2001 was $3.37 and $3.21,respectively.

 

The following table showsthe minimum capital requirement and our capital position at December 31, 2003,2002, and 2001 for the consolidated bank holding company.  Our regulatory capital levels for the bankand bank holding company meet those established for well-capitalizedinstitutions.

 

**Capital Components**

At December 31, 2003, 2002 and 2001

(Dollars in thousands)

 
|                                                             |   | **Actual** |   | **For  Capital  Adequacy Purposes** |   | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** |   |
|------------------------------------------------------------------|--------|------------|--------|-------------------------------------|--------|-------------------------------------------------------------------------|--------|
|                                                             |   | **Amount** |   | **Ratio**                           |   | **Amount**                                                              |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
|                                                             |   |       |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| **At December 31, 2003**                                         |   |       |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total risk based capital/ Total capital to  risk-weighted assets |   | $          | 90,239 |                                | 20.66  | %                                                                       | $      | 34,951 | > | 8.00 | % | $ | 43,688 | > | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets          |   | 85,896     |   | 19.66                               | %      | 17,475                                                                  | >   | 4.00 | % | 26,213 | > | 6.00 | % |
| Total risk based capital/ Total capital to  average assets       |   | 85,896     |   | 15.45                               | %      | 23,365                                                                  | >   | 4.00 | % | 29,206 | > | 5.00 | % |
|                                                             |   |       |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| **At December 31, 2002**                                         |   |       |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total risk based capital/ Total capital to  risk-weighted assets |   | $          | 41,093 |                                | 13.35  | %                                                                       | $      | 24,625 | > | 8.00 | % | $ | 30,781 | > | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets          |   | 37,721     |   | 12.25                               | %      | 12,313                                                                  | >   | 4.00 | % | 18,469 | > | 6.00 | % |
| Total risk based capital/ Total capital to  average assets       |   | 37,721     |   | 8.97                                | %      | 18,330                                                                  | >   | 4.00 | % | 15,391 | > | 5.00 | % |
|                                                             |   |       |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| **At December 31, 2001**                                         |   |       |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total risk based capital/ Total capital to  risk-weighted assets |   | $          | 23,333 |                                | 10.42  | %                                                                       | $      | 17,909 | > | 8.00 | % | $ | 22,387 | > | 10.00 | % |
| Tier I capital/ Tier I capital to  risk-weighted assets          |   | 20,230     |   | 9.04                                | %      | 8,955                                                                   | >   | 4.00 | % | 13,432 | > | 6.00 | % |
| Total risk based capital/ Total capital to  average assets       |   | 20,230     |   | 8.57                                | %      | 10,891                                                                  | >   | 4.00 | % | 13,614 | > | 5.00 | % |

 

47

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**Liquidity**

 

The objective of liquiditymanagement is to ensure the continuous availability of funds to meet thedemands of depositors, investors and borrowers.  Stable core deposits and a strong capital position are thecurrent components of a solid foundation for our liquidity position.  In addition, the availability of regionaland national wholesale funding sources including federal funds purchased,negotiable certificates of deposit, securities sold under agreements torepurchase, and borrowings from the Federal Home Loan Bank enhance ourliquidity.  Cash flows from operations,such as loan payments and payoffs are also a significant source ofliquidity.  We have a contingency planthat provides for continued monitoring of liquidity needs and available sourcesof liquidity.  We believe we have theability to meet our increased liquidity needs. Liquid assets, which include cash and due from banks, federal funds soldand investment securities available for sale, at December 31, 2003, totaled$143.8 million, or 22.6% of total assets. We have investment securities that are classified as held-to-maturity of$142.9 million at December 31, 2003.  Wehave $177.5 million of our investment securities portfolio pledged ascollateral for our other borrowed funds at December 31, 2003.  Management is committed to maintainingliquidity at a level sufficient to protect depositors, provide for reasonablegrowth and fully comply with all regulatory requirements.

 

**ContractualObligations**

 

Wehave entered into a number of long-term contractual obligations to support ourongoing activities.  These contractualobligations will be funded through operating revenues and liquidity sourcesheld or available to us.  The requiredpayments under such obligations were as follows:

 

**Contractual Obligations**

AtDecember 31, 2003

(Dollarsin thousands)

 
|                                                 |   | **Payments  Due by Period** |    |
|------------------------------------------------------|--------|-----------------------------|---------|
|                                                 |   | **Total**                   |    | **Less than  1  Year** |   | **1 - 2  Years** |   | **3 - 5  Years** |   | **More  than 5  Years** |   |
| Certificates of deposit of  $100,000 or more         |   | $                           | 103,600 |   | $ | 69,037 |   | $ | 22,889 |   | $ | 11,674 |   | $ | — |   |
| Advances from the Federal  Home Loan Bank of Atlanta |   | 48,958                      |    | 24,500 |   | 13,250 |   | 11,208 |   | — |   |
|                                                 |   |                        |    |   |   |   |   |   |   |   |   |
| Operating lease  obligations                         |   | 12,400                      |    | 1,962 |   | 4,091 |   | 5,538 |   | 809 |   |
|                                                 |   |                        |    |   |   |   |   |   |   |   |   |
| Total                                                |   | $                           | 164,958 |   | $ | 95,499 |   | $ | 40,230 |   | $ | 28,420 |   | $ | 809 |   |

 

**QuarterlyData**

 

The following table providesquarterly data for the years ended December 31, 2003 and 2002.  Quarterly per share results may notcalculate to the year end per share results due to rounding.

 

**QuarterlyData**

Years ended December 31,2003 and 2002

(Dollars in thousands,except per share data)

 
|                                                |   | **2003**            |   |
|-----------------------------------------------------|--------|---------------------|--------|
|                                                |   | **Fourth  Quarter** |   | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
| Interest income                                     |   | $                   | 6,864  |   | $ | 6,179 |   | $ | 5,787 |   | $ | 5,772 |   |
| Interest expense                                    |   | 2,432               |   | 2,341 |   | 2,343 |   | 2,313 |   |
|                                                |   |                |   |   |   |   |   |   |   |
| Net interest income                                 |   | 4,432               |   | 3,838 |   | 3,444 |   | 3,459 |   |
| Provision for loan losses                           |   | (399                | )      | (356 | ) | (166 | ) | (80 | ) |
|                                                |   |                |   |   |   |   |   |   |   |
| Net interest income after provision for loan losses |   | 4,033               |   | 3,482 |   | 3,278 |   | 3,379 |   |
| Non-interest income                                 |   | 833                 |   | 971 |   | 1,049 |   | 976 |   |
| Non-interest expense                                |   | 4,148               |   | 3,684 |   | 3,658 |   | 3,865 |   |
|                                                |   |                |   |   |   |   |   |   |   |
| Net income before income taxes                      |   | 718                 |   | 769 |   | 669 |   | 490 |   |
| Income tax benefit                                  |   | (3,508              | )      | — |   | — |   | — |   |
| Net income                                          |   | $                   | 4,226  |   | $ | 769 |   | $ | 669 |   | $ | 490 |   |
| Dividends to preferred shareholders                 |   | 123                 |   | 124 |   | 124 |   | 124 |   |
| Net income to common shareholders                   |   | $                   | 4,103  |   | $ | 645 |   | $ | 545 |   | $ | 366 |   |
| Earnings per common share, basic                    |   | $                   | 0.38   |   | $ | 0.06 |   | $ | 0.05 |   | $ | 0.04 |   |
| Earnings per common share, diluted                  |   | $                   | 0.37   |   | $ | 0.06 |   | $ | 0.05 |   | $ | 0.04 |   |

 
|                                                |   | **2002**            |   |
|-----------------------------------------------------|--------|---------------------|--------|
|                                                |   | **Fourth  Quarter** |   | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
| Interest income                                     |   | $                   | 5,325  |   | $ | 5,484 |   | $ | 5,039 |   | $ | 4,394 |   |
| Interest expense                                    |   | 2,544               |   | 2,643 |   | 2,379 |   | 2,020 |   |
|                                                |   |                |   |   |   |   |   |   |   |
| Net interest income                                 |   | 2,781               |   | 2,841 |   | 2,660 |   | 2,374 |   |
| Provision for loan losses                           |   | (310                | )      | (95 | ) | (39 | ) | — |   |
|                                                |   |                |   |   |   |   |   |   |   |
| Net interest income after provision for loan losses |   | 2,471               |   | 2,746 |   | 2,621 |   | 2,374 |   |
| Non-interest income                                 |   | 971                 |   | 634 |   | 551 |   | 708 |   |
| Non-interest expense                                |   | 3,234               |   | 2,951 |   | 4,400 |   | 3,020 |   |
|                                                |   |                |   |   |   |   |   |   |   |
| Net income (loss) before income taxes               |   | 208                 |   | 429 |   | (1,228 | ) | 62 |   |
| Provision for income taxes                          |   | —              |   | — |   | — |   | — |   |
| Net income (loss)                                   |   | $                   | 208    |   | $ | 429 |   | $ | (1,228 | ) | $ | 62 |   |
| Dividends to preferred shareholders                 |   | 123                 |   | 124 |   | 124 |   | 124 |   |
| Net income (loss) to common shareholders            |   | $                   | 85     |   | $ | 305 |   | $ | (1,352 | ) | $ | (62 | ) |
| Basic and diluted income (loss) per common share    |   | $                   | 0.01   |   | $ | 0.03 |   | $ | (0.18 | ) | $ | (0.01 | ) |

 

48

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**Item 7**.  FinancialStatements

** **

#### **Independent Auditor’sReport of KPMG LLP**

#### ** **

The Board of Directors andShareholders

Cardinal Financial Corporationand subsidiaries:

 

We have audited the accompanying consolidatedstatements of condition of Cardinal Financial Corporation and subsidiaries (theCompany) as of December 31, 2003 and 2002, and the related consolidatedstatements of operations, comprehensive income (loss), changes in shareholders’equity, and cash flows for each of the years in the three-year period endedDecember 31, 2003.  These consolidatedfinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our audits in accordance withauditing standards generally accepted in the United States of America.  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financial statementsare free of material misstatement.  Anaudit includes examining, on a test basis, evidence supporting amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, thefinancial position of Cardinal Financial Corporation and subsidiaries as ofDecember 31, 2003 and 2002, and the results of their operations and their cashflows for each of the years in the three-year period ended December 31, 2003,in conformity with accounting principles generally accepted in the UnitedStates of America.

 

 
| /s/KPMG LLP       |   |
|-------------------|--------|
|              |
| McLean,  Virginia |
| January 14,  2004 |

 

49

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATEDSTATEMENTS OF CONDITION

 

December31, 2003 and 2002

 

(Dollarsin thousands, except share data)

 

 
|                                                                                                                                                                                        |   | **2003** |       | **2002** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **Assets**                                                                                                                                                                                  |   |     | ** ** |     | ** ** |
| Cash and due from banks                                                                                                                                                                     |   | $        | 9,555      |     | $          | 27,465 |   |
| Federal funds sold                                                                                                                                                                          |   | 3,528    |       | 35,906   |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Total cash and cash  equivalents                                                                                                                                                            |   | 13,083   |       | 63,371   |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Investment securities  available-for-sale                                                                                                                                                   |   | 130,762  |       | 163,665  |       |
| Investment securities  held-to-maturity                                                                                                                                                     |   | 142,852  |       | —   |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Total investment  securities                                                                                                                                                                |   | 273,614  |       | 163,665  |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Other investments                                                                                                                                                                           |   | 3,517    |       | 1,615    |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Loans receivable, net of  fees                                                                                                                                                              |   | 336,002  |       | 249,106  |       |
| Allowance for loan losses                                                                                                                                                                   |   | (4,344   | )          | (3,372   | )          |
|                                                                                                                                                                                        |   |     |       |     |       |
| Loans receivable, net                                                                                                                                                                       |   | 331,658  |       | 245,734  |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Premises and equipment,  net                                                                                                                                                                |   | 6,707    |       | 4,942    |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Deferred tax asset                                                                                                                                                                          |   | 4,473    |       | —   |       |
| Goodwill                                                                                                                                                                                    |   | 22       |       | 646      |       |
| Accrued interest and other  assets                                                                                                                                                          |   | 3,174    |       | 6,350    |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Total assets                                                                                                                                                                                |   | $        | 636,248    |     | $          | 486,323 |   |
|                                                                                                                                                                                        |   |     |       |     |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                               |   |     |       |     |       |
| Deposits                                                                                                                                                                                    |   | $        | 474,129    |     | $          | 423,479 |   |
| Other borrowed funds                                                                                                                                                                        |   | 74,457   |       | 2,000    |       |
| Accrued interest and other  liabilities                                                                                                                                                     |   | 2,250    |       | 20,132   |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Total liabilities                                                                                                                                                                           |   | 550,836  |       | 445,611  |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Preferred stock, $1 par  value, 10,000,000 shares authorized;  Series A preferred stock, cumulative convertible, 1,364,062 and 1,364,684  shares outstanding in 2003 and 2002, respectively |   | 1,364    |       | 1,365    |       |
| Common stock, $1 par  value, 50,000,000 shares authorized;  16,377,337 and 10,044,345 shares outstanding in 2003 and 2002, respectively                                                     |   | 16,377   |       | 10,044   |       |
| Additional paid-in capital                                                                                                                                                                  |   | 86,790   |       | 51,231   |       |
| Accumulated deficit                                                                                                                                                                         |   | (18,614  | )          | (24,273  | )          |
| Accumulated other comprehensive  income (loss)                                                                                                                                              |   | (505     | )          | 2,345    |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Total shareholders’ equity                                                                                                                                                             |   | 85,412   |       | 40,712   |       |
|                                                                                                                                                                                        |   |     |       |     |       |
| Total liabilities and  shareholders’ equity                                                                                                                                            |   | $        | 636,248    |     | $          | 486,323 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

50

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 

Yearsended December 31, 2003, 2002 and 2001

(Inthousands, except per share data)

 
|                                                           |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Interest income:                                               |   |     |   |     |   |     |   |
| Loans receivable                                               |   | $        | 16,851 |     | $      | 14,798   |   | $ | 14,973 |   |
| Federal funds sold                                             |   | 107      |   | 871      |   | 1,085    |   |
| Investment securities  available-for-sale                      |   | 5,026    |   | 4,501    |   | 437      |   |
| Investment securities  held-to-maturity                        |   | 2,483    |   | —   |   | —   |   |
| Other investments                                              |   | 135      |   | 72       |   | 82       |   |
| Total interest income                                          |   | 24,602   |   | 20,242   |   | 16,577   |   |
| Interest expense:                                              |   |     |   |     |   |     |   |
| Deposits                                                       |   | 8,656    |   | 9,364    |   | 7,027    |   |
| Other borrowed funds                                           |   | 773      |   | 222      |   | 473      |   |
| Total interest expense                                         |   | 9,429    |   | 9,586    |   | 7,500    |   |
| Net interest income                                            |   | 15,173   |   | 10,656   |   | 9,077    |   |
| Provision for loan losses                                      |   | 1,001    |   | 444      |   | 1,202    |   |
| Net interest income after  provision for loan losses           |   | 14,172   |   | 10,212   |   | 7,875    |   |
| Non-interest income:                                           |   |     |   |     |   |     |   |
| Service charges on deposit  accounts                           |   | 631      |   | 511      |   | 398      |   |
| Loan service charges                                           |   | 382      |   | 392      |   | 433      |   |
| Investment fee income                                          |   | 785      |   | 940      |   | 1,941    |   |
| Net gain on sales of loans                                     |   | 282      |   | 74       |   | 49       |   |
| Net realized gain on  investment securities available-for-sale |   | 1,364    |   | 524      |   | —   |   |
| Net gain on sales of  assets                                   |   | —   |   | 39       |   | 18       |   |
| Other income                                                   |   | 385      |   | 384      |   | 318      |   |
| Total non-interest income                                      |   | 3,829    |   | 2,864    |   | 3,157    |   |
| Non-interest expense:                                          |   |     |   |     |   |     |   |
| Salary and benefits                                            |   | 6,726    |   | 5,715    |   | 7,731    |   |
| Occupancy                                                      |   | 1,559    |   | 972      |   | 1,263    |   |
| Professional fees                                              |   | 1,113    |   | 1,011    |   | 705      |   |
| Depreciation                                                   |   | 1,030    |   | 736      |   | 804      |   |
| Writedown on corporate  bond                                   |   | —   |   | 1,660    |   | —   |   |
| Amortization and writedown  of intangibles                     |   | —   |   | 22       |   | 8,907    |   |
| Other operating expenses                                       |   | 4,927    |   | 3,489    |   | 4,346    |   |
| Total non-interest expense                                     |   | 15,355   |   | 13,605   |   | 23,756   |   |
| Net income (loss) before  income taxes                         |   | 2,646    |   | (529     | )      | (12,724  | )      |
| Income tax benefit                                             |   | (3,508   | )      | —   |   | —   |   |
| Net income (loss)                                              |   | $        | 6,154  |     | $      | (529     | )      | $ | (12,724 | ) |
| Dividends to preferred  shareholders                           |   | 495      |   | 495      |   | 503      |   |
| Net income (loss) to  common shareholders                      |   | $        | 5,659  |     | $      | (1,024   | )      | $ | (13,227 | ) |
| Earnings (loss) per common  share - basic                      |   | $        | 0.55   |     | $      | (0.13    | )      | $ | (3.11 | ) |
| Earnings (loss) per common  share - diluted                    |   | $        | 0.54   |     | $      | (0.13    | )      | $ | (3.11 | ) |
| Weighted-average common  shares outstanding - basic            |   | 10,218   |   | 7,949    |   | 4,258    |   |
| Weighted-average common  shares outstanding - diluted          |   | 10,445   |   | 7,949    |   | 4,258    |   |

 

See accompanying notes to consolidatedfinancial statements.

 

51

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME (LOSS)

Yearsended December 31, 2003, 2002 and 2001

(Dollarsin thousands)

 

 
|                                                                                   |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                   |   |     |   |     |   |     |   |
| Net income (loss)                                                                      |   | $        | 6,154  |     | $      | (529     | )      | $ | (12,724 | ) |
| Other comprehensive income  (loss):                                                    |   |     |   |     |   |     |   |
| Unrealized gain (loss) on  available-for-sale investment securities:                   |   |     |   |     |   |     |   |
| Unrealized holding gain  (loss) arising during the year, net of tax                    |   | (1,950   | )      | 3,143    |   | (278     | )      |
| Less: reclassification  adjustment for gains included in net income (loss), net of tax |   | 900      |   | 524      |   | —   |   |
|                                                                                   |   |     |   |     |   |     |   |
| Comprehensive income  (loss)                                                           |   | $        | 3,304  |     | $      | 2,090    |   | $ | (13,002 | ) |

 

See accompanying notes to consolidatedfinancial statements.

 

52

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Years ended December 31, 2003, 2002 and 2001

(In thousands)

 
|                                                                                      |   | **Preferred  Shares** |   | **Preferred  Stock** |   | **Common  Shares** |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Accumulated  Deficit** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Total** |   |
|-------------------------------------------------------------------------------------------|--------|-----------------------|--------|----------------------|--------|--------------------|--------|-------------------|--------|----------------------------------|--------|--------------------------|--------|------------------------------------------------------|--------|-----------|--------|
| Balance, December 31, 2000                                                                |   | 1,411                 |   | $                    | 1,411  |               | 4,253  |              | $      | 4,253                            |   | $                        | 38,466 |                                                 | $      | (10,022   | )      | $ | 4 |   | $ | 34,112 |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Issuance of stock awards                                                                  |   | —                |   | —               |   | 3                  |   | 3                 |   | 3                                |   | —                   |   | —                                               |   | 6         |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Stock options exercised                                                                   |   | —                |   | —               |   | 3                  |   | 3                 |   | 8                                |   | —                   |   | —                                               |   | 11        |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Dividends on preferred stock                                                              |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (503                     | )      | —                                               |   | (503      | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Preferred stock converted to common stock                                                 |   | (46                   | )      | (46                  | )      | 35                 |   | 35                |   | 11                               |   | —                   |   | —                                               |   | —    |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Change in unrealized gain (loss) on investment  securities available-for-sale             |   | —                |   | —               |   | —             |   | —            |   | —                           |   | —                   |   | (278                                                 | )      | (278      | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Net loss                                                                                  |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (12,724                  | )      | —                                               |   | (12,724   | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Balance, December 31, 2001                                                                |   | 1,365                 |   | $                    | 1,365  |               | 4,294  |              | $      | 4,294                            |   | $                        | 38,488 |                                                 | $      | (23,249   | )      | $ | (274 | ) | $ | 20,624 |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Rights offering shares issued                                                             |   | —                |   | —               |   | 2,437              |   | 2,437             |   | 5,462                            |   | —                   |   | —                                               |   | 7,899     |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Public offering shares issued                                                             |   | —                |   | —               |   | 3,313              |   | 3,313             |   | 7,281                            |   | —                   |   | —                                               |   | 10,594    |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Dividends on preferred stock                                                              |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (495                     | )      | —                                               |   | (495      | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Change in unrealized gain (loss) on investment  securities available-for-sale             |   | —                |   | —               |   | —             |   | —            |   | —                           |   | —                   |   | 2,619                                                |   | 2,619     |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Net loss                                                                                  |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (529                     | )      | —                                               |   | (529      | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Balance, December 31, 2002                                                                |   | 1,365                 |   | $                    | 1,365  |               | 10,044 |              | $      | 10,044                           |   | $                        | 51,231 |                                                 | $      | (24,273   | )      | $ | 2,345 |   | $ | 40,712 |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Stock options exercised                                                                   |   | —                |   | —               |   | 32                 |   | 32                |   | 112                              |   | —                   |   | —                                               |   | 144       |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Preferred stock converted to common stock                                                 |   | (1                    | )      | (1                   | )      | 1                  |   | 1                 |   | —                           |   | —                   |   | —                                               |   | —    |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Public offering shares issued                                                             |   | —                |   | —               |   | 6,300              |   | 6,300             |   | 35,447                           |   | —                   |   | —                                               |   | 41,747    |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Dividends on preferred stock                                                              |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (495                     | )      | —                                               |   | (495      | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Change in unrealized gain (loss) on investment  securities available-for-sale, net of tax |   | —                |   | —               |   | —             |   | —            |   | —                           |   | —                   |   | (2,850                                               | )      | (2,850    | )      |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Net income                                                                                |   | —                |   | —               |   | —             |   | —            |   | —                           |   | 6,154                    |   | —                                               |   | 6,154     |   |
|                                                                                      |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Balance, December 31, 2003                                                                |   | 1,364                 |   | $                    | 1,364  |               | 16,377 |              | $      | 16,377                           |   | $                        | 86,790 |                                                 | $      | (18,614   | )      | $ | (505 | ) | $ | 85,412 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31, 2003, 2002 and 2001

(Dollars in thousands)

 
|                                                                                                |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash flows from operating activities:                                                               |   |     |   |     |   |     |   |
| Net income (loss)                                                                                   |   | $        | 6,154  |     | $      | (529     | )      | $ | (12,724 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |   |     |   |     |   |     |   |
| Depreciation                                                                                        |   | 1,030    |   | 736      |   | 804      |   |
| Amortization and writedown of intangibles,  premiums and discounts                                  |   | 2,137    |   | 1,120    |   | 8,960    |   |
| Provision for loan losses                                                                           |   | 1,001    |   | 444      |   | 1,202    |   |
| Originations of loans held for sale                                                                 |   | (32,697  | )      | (4,369   | )      | (15,807  | )      |
| Proceeds from the sale of loans held for sale                                                       |   | 32,979   |   | 9,175    |   | 11,124   |   |
| Writedown on corporate bond                                                                         |   | —   |   | 1,660    |   | —   |   |
| Gain on sale of loans held for sale                                                                 |   | (282     | )      | (74      | )      | (49      | )      |
| Gain on sale of investment securities available-for-sale                                            |   | (1,364   | )      | (524     | )      | —   |   |
| Gain on sale of other assets                                                                        |   | —   |   | (39      | )      | (18      | )      |
| (Increase) decrease in accrued interest, other  assets, goodwill and deferred tax asset             |   | (673     | )      | (4,924   | )      | 117      |   |
| Increase (decrease) in accrued interest and other  liabilities                                      |   | (17,882  | )      | 17,020   |   | 834      |   |
| Compensation related to stock awards                                                                |   | —   |   | —   |   | 6        |   |
|                                                                                                |   |     |   |     |   |     |   |
| Net cash provided by (used in) operating  activities                                                |   | (9,597   | )      | 19,696   |   | (5,551   | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Cash flows from investing activities:                                                               |   |     |   |     |   |     |   |
| Purchase of premises and equipment                                                                  |   | (2,795   | )      | (601     | )      | (501     | )      |
| Proceeds from sale of premises and equipment                                                        |   | —   |   | —   |   | 28       |   |
| Proceeds from sale, maturity and call of  investment securities available-for-sale                  |   | 97,614   |   | 42,034   |   | 4,500    |   |
| Proceeds from sale of other investments                                                             |   | 1,831    |   | 188      |   | 832      |   |
| Purchase of investment securities  available-for-sale                                               |   | (266,571 | )      | (197,255 | )      | (34,101  | )      |
| Purchase of investment securities held-to-maturity                                                  |   | (8,021   | )      | —   |   | —   |   |
| Purchase of other investments                                                                       |   | (3,733   | )      | (535     | )      | (587     | )      |
| Redemptions of investment securities available-for-sale                                             |   | 41,805   |   | 25,564   |   | 2,111    |   |
| Redemptions of investment securities  held-to-maturity                                              |   | 21,340   |   | —   |   | —   |   |
| Net increase in loans receivable                                                                    |   | (86,664  | )      | (47,808  | )      | (46,458  | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Net cash used in investing activities                                                               |   | (205,194 | )      | (178,413 | )      | (74,176  | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Cash flows from financing activities:                                                               |   |     |   |     |   |     |   |
| Net increase in deposits                                                                            |   | 50,650   |   | 177,455  |   | 82,653   |   |
| Net increase (decrease) in other borrowed funds                                                     |   | 25,499   |   | (24      | )      | (1,263   | )      |
| Proceeds from FHLB advances - long term                                                             |   | 59,000   |   | 1,000    |   | 3,800    |   |
| Repayments of FHLB advances - long term                                                             |   | (12,042  | )      | (8,800   | )      | —   |   |
| Proceeds from rights offering                                                                       |   | —   |   | 7,899    |   | —   |   |
| Proceeds from public offering                                                                       |   | 41,747   |   | 10,594   |   | —   |   |
| Stock options exercised                                                                             |   | 144      |   | —   |   | 11       |   |
| Dividends on preferred stock                                                                        |   | (495     | )      | (495     | )      | (503     | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Net cash provided by financing activities                                                           |   | 164,503  |   | 187,629  |   | 84,698   |   |
|                                                                                                |   |     |   |     |   |     |   |
| Net increase (decrease) in cash and cash  equivalents                                               |   | (50,288  | )      | 28,912   |   | 4,971    |   |
|                                                                                                |   |     |   |     |   |     |   |
| Cash and cash equivalents at beginning of year                                                      |   | 63,371   |   | 34,459   |   | 29,488   |   |
|                                                                                                |   |     |   |     |   |     |   |
| Cash and cash equivalents at end of year                                                            |   | $        | 13,083 |     | $      | 63,371   |   | $ | 34,459 |   |
|                                                                                                |   |     |   |     |   |     |   |
| **Supplemental disclosure of cash  flow information:**                                              |   |     |   |     |   |     |   |
| Cash paid during year for interest                                                                  |   | $        | 9,380  |     | $      | 9,491    |   | $ | 7,538 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

Notes to ConsolidatedFinancial Statements

** **

(1)                      Organization

 

Cardinal Financial Corporation(the ”Company”) was incorporated November 24, 1997 under the laws ofthe Commonwealth of Virginia as a holding company whose activities consist ofinvestment in its wholly-owned subsidiaries. In addition to Cardinal Bank, N.A., which began operations in 1998, theCompany opened the following three subsidiaries in 1999, Cardinal *WealthServices, Inc.* an investment subsidiary (as of February 1, 1999),Cardinal Bank – *Manassas/Prince William*, N.A. (as of July 26, 1999), andCardinal Bank – *Dulles*, N.A. (as of August 2, 1999).  On September 1, 2000, the Company completedits acquisition of Heritage Bancorp, Inc. and its banking subsidiary, TheHeritage Bank, headquartered in McLean, Virginia.  The Heritage Bank was renamed and became the Company’s fourthbanking subsidiary, Cardinal Bank – *Potomac*. On November 1, 2001, the Company consolidated two of its bankingsubsidiaries, Cardinal Bank – *Dulles*, N.A. and Cardinal Bank – *Potomac*into Cardinal Bank, N.A.  On March 1,2002, the Company consolidated Cardinal Bank – *Manassas/ Prince William,*N.A. into Cardinal Bank, N.A., the Company’s only remaining banking subsidiary.

** **

(2)                      Summary of Significant AccountingPolicies

*** ***

***(a)***                     Use of Estimates

*** ***

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and contingent liabilities atthe date of the consolidated financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from those estimates.  Material estimates that are particularlysusceptible to changes in the near term are the allowance for loan losses, thevaluation of deferred tax assets, and the determination of impairment oninvestment securities.

 

***(b)***                     Principles of Consolidation

*** ***

Theconsolidated financial statements include the accounts of the Company and itssubsidiaries.  All significantintercompany transactions and balances have been eliminated in consolidation.

 

***(c)***                      Cash and Cash Equivalents

*** ***

Forthe purpose of presentation in the consolidated statements of cash flows, theCompany has defined cash and cash equivalents as those amounts included in cash,due from banks, and federal funds sold.

*** ***

***(d)***                     Investment Securities

*** ***

TheCompany classifies its debt and marketable equity securities in one of twocategories:  available-for-sale orheld-to-maturity.  Held-to-maturitysecurities are

 

55

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thosesecurities for which the Company has the ability and intent to hold untilmaturity.  All other securities areclassified as available-for-sale.

 

Heldto maturity securities are held at cost. Available-for-sale securities are recorded at fair value.  Unrealized gains and losses, net of tax ifapplicable, on available-for-sale securities are reported in othercomprehensive income (loss).

 

Gainsand losses on the sale of securities are determined using the specific identificationmethod.  Declines in the fair value ofindividual held-to-maturity and available-for-sale securities below their costthat are deemed other than temporary are charged to earnings as realizedlosses, resulting in the establishment of a new cost basis for the security.

 

Premiumsand discounts are recognized in interest income using the effective interestmethod over the period to maturity. Prepayment of the mortgages securing the mortgage-backed securities mayaffect the maturity date and yield to maturity.  The Company uses actual principal prepayment experience andestimates of future principal prepayments in calculating the yield necessary toapply the effective interest method.

 

***(e)***                      Loans Receivable and Allowance for Loan Losses

*** ***

Loansreceivable that management has the intent and ability to hold for theforeseeable future or until maturity or pay-off are reported at theiroutstanding principal balance adjusted for any charge-offs, and net of theallowance for loan losses and any deferred fees or costs.  Loan origination fees and certain directorigination costs are capitalized and amortized as an adjustment of the yieldof the related loan.

 

Loansare placed in nonaccrual status when they are past-due 90 days as toeither principal or interest or when, in the opinion of management, thecollection of principal and interest is in doubt.  A loan remains in nonaccrual status until the loan is current asto payment of both principal and interest or past-due less than 90 days,and the borrower demonstrates the ability to pay and remain current.  Loans are charged-off when a loan or aportion thereof is considered uncollectible. When cash payments are received, they are applied to principal first,then accrued interest.  It is theCompany’s policy not to record interest income on nonaccrual loans untilprincipal has become current.

 

TheCompany determines and recognizes impairment of certain loans when, based oncurrent information and events, it is probable that the Company will be unableto collect all amounts due according to the contractual terms of the loanagreement.  A loan is not consideredimpaired during a period of delay in payment if the Company expects to collectall amounts due, including past-due interest. An impaired loan is measured at the present value of its expected futurecash flows discounted at the loan’s effective interest rate, or at the loan’sobservable market price or fair value of the collateral if the loan iscollateral dependent.

 

56

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Theallowance for loan losses is increased by provisions for loan losses anddecreased by charge-offs (net of recoveries). Management’s periodic determination of the allowance is based on theCompany’s past loan loss experience, adverse situations that may affect theborrower’s ability to repay, the estimated value of any underlying collateral,and current economic conditions.  Inaddition, various regulatory agencies, as an integral part of their examinationprocess, periodically review the Company’s allowance for loan losses.  Such agencies may require the Company torecognize additions to the allowance based on their judgments about informationavailable to them at the time of their examination.  Management believes that the current allowance for loan losses isa reasonable estimate of known and inherent losses in the current loanportfolio.

 

***(f)***                        Premises and Equipment

*** ***

Landis carried at cost.  Premises,furniture, equipment, and leasehold improvements are carried at cost, lessaccumulated depreciation and amortization. Depreciation of premises, furnitureand equipment is computed using the straight-line method over their estimateduseful lives from 3 to 10 years. Amortization of leasehold improvements iscomputed using the straight-line method over the useful lives of theimprovements or the lease term, whichever is shorter.

*** ***

***(g)***                     Goodwill and Other Intangibles

*** ***

***Goodwill, whichrepresents the excess of purchase price over fair value of net assets acquired,is***evaluatedat least annually for impairment by comparing its fair value with its recordedamount and is written-down when appropriate. In 2003, the Company evaluated impairment of goodwill under SFAS No.142. The evaluation of goodwill under this statement did not result inimpairment of the goodwill for the year ended December 31, 2003.  However, as disclosed in Footnote 19,goodwill was reduced in 2003 as a result of the recognition of deferred taxassets associated with net operating loss carryforwards of an acquired entity.

*** ***

***(h)***                     Investment Fee Income

*** ***

Investment fee income represents commissions paid bycustomers of Cardinal *Wealth Services,**Inc.* for investmenttransactions.  Fees are recognized inincome as they are earned.

 

***(i)***                        Income Taxes

*** ***

Deferredtax assets and liabilities are reflected at currently enacted income tax ratesapplicable to the period in which the deferred tax assets or liabilities areexpected to be realized or settled.  Aschanges in tax laws or rates are enacted, deferred tax assets and liabilitiesare adjusted through the provision for income taxes.

 

57

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***(j)***                        Earnings (Loss) Per Common Share

*** ***

Basicearnings (loss) per common share is computed by dividing net income (loss) bythe weighted-average number of shares of common stock outstanding during theperiods.  Diluted earnings per sharereflects the impact of dilutive potential common shares that would have beenoutstanding if common stock equivalents had been issued, as well as anyadjustment to income that would result from the assumed issuance.  Common stock equivalents that may be issuedby the Company relate solely to outstanding stock options, and the dilutivepotential common shares resulting from outstanding stock options are determinedusing the treasury stock method.  Commonstock equivalents outstanding at December 31, 2002 and 2001 wereantidilutive and consequently, not included in the loss per common sharecalculation.

 

***(k)***                     Stock Option Plans

*** ***

TheCompany applies the intrinsic value-based method of accounting prescribed byAccounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued toEmployees*, and related interpretations, in accounting for its fixedplan stock options.  As such,compensation expense is recorded only if the current market price of theunderlying stock exceeded the exercise price on the date of grant.

 

***(l)***                        Stock Based Compensation

 

AtDecember 31, 2003, the Company had two stock-based employee compensation plans,which are described more fully in Footnote 14. As permitted under SFAS No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure*, which amended SFAS No. 123, *Accounting for Stock-Based Compensation*,the Company has elected to continue to follow the intrinsic value method inaccounting for its stock-based employee compensation arrangement as defined byAccounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued toEmployees*, and related interpretations including *FinancialAccounting Standards Board Interpretation No. 44, Accounting for CertainTransactions involving Stock Compensation*, an interpretation of APBNo. 25.  The following table illustratesthe effect on net income (loss) and earnings (loss) per common share if theCompany had applied the fair value recognition provisions of SFAS No. 123 tostock-based employee compensation.

 

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|                                                  |                                                                                                     | **Years ended December 31,** |   |
|-------------------------------------------------------|----------------------------------------------------------------------------------------------------------|------------------------------|--------|
| **(Dollars in thousands, except per  share data)**    |                                                                                                     | **2003**                     |   | **2002** |   | **2001** |   |
| Net income (loss) to common shareholders as  reported |                                                                                                     | $                            | 5,659  |   | $ | (1,024 | ) | $ | (13,227 | ) |
| Deduct:                                               | Total stock based employee  compensation expense determined under fair value-based method for all awards |                         | (547   | ) | (265 | ) | (138 | ) |
|                                                  |                                                                                                     |                         |   |   |   |   |   |   |
| Pro forma net income (loss)                           |                                                                                                     | $                            | 5,112  |   | $ | (1,289 | ) | $ | (13,365 | ) |
|                                                  |                                                                                                     |                         |   |   |   |   |   |   |
| Earnings (loss) per common share:                     |                                                                                                     |                         |   |   |   |   |   |
|                                                  | Basic - as reported                                                                                      |                         | $      | 0.55 |   | $ | (0.13 | ) | $ | (3.11 | ) |
|                                                  | Basic - pro forma                                                                                        |                         | 0.50   |   | (0.16 | ) | (3.14 | ) |
|                                                  | Diluted - as reported                                                                                    |                         | 0.54   |   | (0.13 | ) | (3.11 | ) |
|                                                  | Diluted - pro forma                                                                                      |                         | 0.49   |   | (0.16 | ) | (3.14 | ) |

 

Theweighted average per share fair values of grants made in 2003, 2002 and 2001were $2.13, $2.12 and $2.04, respectively. The fair values of the options granted were estimated on the grant dateusing the Black-Scholes option-pricing model based on the following weighted-averageassumptions:

 

 
|                    |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------|--------|----------|--------|----------|--------|----------|--------|
|                    |   |     |   |     |   |     |   |
| Estimated option life   |   | 10 years |   | 10 years |   | 10 years |   |
| Risk free interest rate |   | 3.98     | %      | 4.25     | %      | 4.90     | %      |
| Expected volatility     |   | 11.8     | %      | 20.4     | %      | 36.3     | %      |
| Expected dividend yield |   | 0.00     | %      | 0.00     | %      | 0.00     | %      |

 

***(m)***                  Reclassifications

*** ***

Certainamounts for 2002 and 2001 have been reclassified to conform to the presentationfor 2003.

 

59

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(3)                      Investment Securities and OtherInvestments

 

**Thefair value and amortized cost of investment securities at December 31,2003 and 2002 are shown below.**

 
|                                                               |   | **2003**            |       |
|--------------------------------------------------------------------|--------|---------------------|------------|
| **(Dollars in thousands)**                                         |   | **Amortized  cost** |       | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  value** |   |
| *Investment Securities  Available-for-Sale*                        |   |                | ** ** |   | ** ** |   | ** ** |   | ** ** |
|                                                               |   |                |       |   |   |   |   |   |   |
| Obligations of U.S. government-sponsored agencies  and enterprises |   | $                   | 6,000      |   | $ | 66 |   | $ | (37 | ) | $ | 6,029 |   |
| Mortgage-backed securities                                         |   | 113,480             |       | 304 |   | (1,113 | ) | 112,671 |   |
| Corporate bonds                                                    |   | 10,000              |       | — |   | (5 | ) | 9,995 |   |
| Treasury bonds                                                     |   | 2,047               |       | 20 |   | — |   | 2,067 |   |
| Total                                                              |   | $                   | 131,527    |   | $ | 390 |   | $ | (1,155 | ) | $ | 130,762 |   |
|                                                               |   |                |       |   |   |   |   |   |   |
| *Investment Securities  Held-to-Maturity*                          |   |                | ** ** |   | ** ** |   | ** ** |   | ** ** |
|                                                               |   |                |       |   |   |   |   |   |   |
| Obligations of U.S. government-sponsored agencies  and enterprises |   | $                   | 16,992     |   | $ | 9 |   | $ | (216 | ) | $ | 16,785 |   |
| Mortgage-backed securities                                         |   | 117,860             |       | 266 |   | (1,129 | ) | 116,997 |   |
| Corporate bonds                                                    |   | 8,000               |       | — |   | (152 | ) | 7,848 |   |
| Total                                                              |   | $                   | 142,852    |   | $ | 275 |   | $ | (1,497 | ) | $ | 141,630 |   |

 
|                                                               |   | **2002**            |    |
|--------------------------------------------------------------------|--------|---------------------|---------|
| **(Dollars in thousands)**                                         |   | **Amortized  cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  value** |   |
| *Investment Securities  Available-for-Sale*                        |   |                |    |   |   |   |   |   |   |
|                                                               |   |                |    |   |   |   |   |   |   |
| Obligations of U.S. government-sponsored agencies  and enterprises |   | $                   | 38,787  |   | $ | 249 |   | $ | — |   | $ | 39,036 |   |
| Mortgage-backed securities                                         |   | 115,026             |    | 2,080 |   | (27 | ) | 117,079 |   |
| Corporate bonds                                                    |   | 5,000               |    | — |   | — |   | 5,000 |   |
| Treasury bonds                                                     |   | 2,507               |    | 43 |   | — |   | 2,550 |   |
| Total                                                              |   | $                   | 161,320 |   | $ | 2,372 |   | $ | (27 | ) | $ | 163,665 |   |

 

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**Thefair value and amortized cost of available-for-sale securities by contractualmaturity at December 31, 2003 is shown below.  Expected maturities may differ from contractual maturitiesbecause many issuers have the right to call or prepay obligations with orwithout call or prepayment penalties.**

 
|                              |   | **Available-for-Sale** |    | **Held-to-Maturity** |   |
|-----------------------------------|--------|------------------------|---------|----------------------|--------|
| **(Dollars in thousands)**        |   | **Amortized  cost**    |    | **Fair  Value**      |   | **Amortized  cost** |   | **Fair  Value** |   |
| After 1 year but within 5 years   |   | $                      | 5,047   |                 | $      | 5,083 |   | $ | 4,000 |   | $ | 3,951 |   |
| After 5 years but within 10 years |   | 2,000                  |    | 1,986                |   | 9,993 |   | 9,884 |   |
| After 10 years                    |   | 11,000                 |    | 11,022               |   | 10,999 |   | 10,798 |   |
| Mortgage-backed securities        |   | 113,480                |    | 112,671              |   | 117,860 |   | 116,997 |   |
|                              |   |                   |    |                 |   |   |   |   |   |
| Total                             |   | $                      | 131,527 |                 | $      | 130,762 |   | $ | 142,852 |   | $ | 141,630 |   |

 

**Forthe years ended December 31, 2003, 2002, and 2001, proceeds from sales ofinvestment securities available-for-sale amounted to $68.9 million, $31.3million, and $0, respectively.  Grossrealized gains in 2003 and 2002 amounted to $1.4 million and $544,000,respectively.  There were no realized gainsduring 2001.  Gross realized lossesduring 2003, 2002 and 2001 amounted to $0, $20,000, and $0, respectively.**

 

The table below shows the Company’sinvestment securities’ gross unrealized losses and their fair value, aggregatedby investment category and length of time that individual securities have beenin a continuous unrealized loss position, at December 31, 2003.

 

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| **Investment Securities Available-for-Sale**                         |   | **Less than 12 months** |   | **12 months or more** |   | **Total**      |   |
|----------------------------------------------------------------------|--------|-------------------------|--------|-----------------------|--------|----------------|--------|
| **(Dollars in thousands)**                                           |   | **Fair Value**          |   | **Unrealized loss**   |   | **Fair Value** |   | **Unrealized loss** |   | **Fair Value** |   | **Unrealized loss** |   |
| Obligations of U.S. government - sponsored  agencies and enterprises |   | $                       | 963    |                  | $      | (37            | )      | $ | — |   | $ | — |   | $ | 963 |   | $ | (37 | ) |
| Mortgage-backed securities                                           |   | 64,283                  |   | (1,079                | )      | 1,624          |   | (34 | ) | 65,907 |   | (1,113 | ) |
| Corporate bonds                                                      |   | 1,995                   |   | (5                    | )      | —         |   | — |   | 1,995 |   | (5 | ) |
| Total temporarily impaired securities                                |   | $                       | 67,241 |                  | $      | (1,121         | )      | $ | 1,624 |   | $ | (34 | ) | $ | 68,865 |   | $ | (1,155 | ) |

 
| **Investment Securities Held-to-Maturity**                           |   | **Less than 12 months** |   | **12 months or more** |   | **Total**      |   |
|----------------------------------------------------------------------|--------|-------------------------|--------|-----------------------|--------|----------------|--------|
| **(Dollars in thousands)**                                           |   | **Fair Value**          |   | **Unrealized loss**   |   | **Fair Value** |   | **Unrealized loss** |   | **Fair Value** |   | **Unrealized loss** |   |
| Obligations of U.S. government - sponsored  agencies and enterprises |   | $                       | 9,783  |                  | $      | (216           | )      | $ | — |   | $ | — |   | $ | 9,783 |   | $ | (216 | ) |
| Mortgage-backed securities                                           |   | 79,881                  |   | (1,129                | )      | —         |   | — |   | 79,881 |   | (1,129 | ) |
| Corporate bonds                                                      |   | 5,848                   |   | (152                  | )      | —         |   | — |   | 5,848 |   | (152 | ) |
| Total temporarily impaired securities                                |   | $                       | 95,512 |                  | $      | (1,497         | )      | $ | — |   | $ | — |   | $ | 95,512 |   | $ | (1,497 | ) |

 

Investment securities with unrealized lossesare all investment grade and are a result of the economic environment of2003.  Investment securities withunrealized losses have interest rates that are less than the current interestrate environment and not a result of impairment.  Mortgage-backed investment securities, which reflect most of theunrealized losses in the investment securities portfolio, are mostly comprisedof bonds issued by the Federal National Mortgage Association (FNMA), FederalHome Loan Mortgage Corporation (FHLMC) and Government National MortgageAssociation (GNMA), and are supported by pools of residential mortgage loans.

 

Investment securities that were pledged tosecure other borrowed funds at December 31, 2003 and 2002 had fair values of$177.5 million and $20.0 million, respectively.  At December 31, 2003 and 2002, investment securities that werepledged to secure FHLB advances were $58.6 million and $0, respectively.  Investment securities that were pledged tosecure repurchase agreements at December 31, 2003 and 2002 were $102.4 million,and $0, respectively.  Investmentsecurities that were pledged to secure debtor in possession deposit accountsand treasury, tax and loan payments at December 31, 2003 and 2002 were $5.0million and $2.5 million, respectively. At December 31, 2003, the Company had identified and pledged $11.5million in investment securities for possible future FHLB advances.

 

During the thirdquarter of 2003, we transferred $157.8 million in available-for-sale investmentsecurities portfolio to held-to-maturity. The unrealized gains of $322,000 associated with these securities at thedate they were transferred to held-to-maturity will be

 

62

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amortized as anadjustment to the yield of the investment securities portfolio over theremaining contractual life of the securities. These securities are mostly pledged as collateral for Federal Home LoanBank advances and our customer repurchase agreements.

 

**Otherinvestments at December 31, 2003 include $1.0 million of Federal Reserve Bankstock, $2.4 million of Federal Home Loan Bank stock, and $63,000 of CommunityBankers’ Bank stock. As members of the Federal Reserve Bank of Richmond andFederal Home Loan Bank of Atlanta, the Company’s banking subsidiaries arerequired to hold stock in these entities. Stock membership in CommunityBankers’ Bank allows the Company to participate in loan purchases or salesincluding participations.  Theseinvestments are carried at cost since no active trading markets exist.**

** **

(4)                      Loans Receivable

 

The loan portfolio at December 31, 2003and 2002 consists of the following:

 
| **(Dollars in thousands)**    |   | **2003** |    | **2002** |   |
|-------------------------------|--------|----------|---------|----------|--------|
| Commercial and industrial     |   | $        | 57,854  |     | $      | 58,292 |   |
| Real estate - commercial      |   | 139,725  |    | 116,135  |   |
| Real estate - construction    |   | 42,243   |    | 5,781    |   |
| Real estate - residential     |   | 42,495   |    | 31,808   |   |
| Home equity lines             |   | 43,176   |    | 26,831   |   |
| Consumer                      |   | 10,690   |    | 10,235   |   |
|                          |   | 336,183  |    | 249,082  |   |
| Net deferred (fees) costs     |   | (181     | )       | 24       |   |
| Loans receivable, net of fees |   | 336,002  |    | 249,106  |   |
| Allowance for loan losses     |   | (4,344   | )       | (3,372   | )      |
| Loans receivable, net         |   | $        | 331,658 |     | $      | 245,734 |   |

 

**Most of the Company’s loans, commitments and standbyletters of credit have been granted to customers located in the Washington,D.C. metropolitan area.  Theconcentrations of credit by type of loan are set forth above.  As a matter of regulatory restriction, theCompany’s banking subsidiary limits the amount of credit extended to any singleborrower or group of related borrowers.**

 

**Ananalysis of the change in the allowance for loan losses follows:**

 

63

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| **(Dollars in thousands)**                    |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Balance, beginning of year                    |   | $        | 3,372  |     | $      | 3,104    |   | $ | 1,900 |   |
| Provision for loan losses                     |   | 1,001    |   | 444      |   | 1,202    |   |
| Transfer to liability on unfunded commitments |   | —   |   | (74      | )      | —   |   |
| Loans charged off                             |   | (80      | )      | (117     | )      | —   |   |
| Recoveries                                    |   | 51       |   | 15       |   | 2        |   |
| Balance, end of year                          |   | $        | 4,344  |     | $      | 3,372    |   | $ | 3,104 |   |

 

**AtDecember 31, 2003 and 2002, the Company had impaired loans of $390,000 and$917,000, respectively, which were on nonaccrual status.  These impairments had valuation allowancesof $166,000 and $480,000 as of December 31, 2003 and 2002, respectively.  The average balance of impaired loans was$654,000, $568,000 and $207,000 for 2003, 2002 and 2001, respectively.  The Company recorded no interest income onimpaired loans.  Interest income thatwould have been recorded had these loans been performing would have been$39,000 for 2003, $37,000 for 2002 and $17,000 for 2001.**

** **

(5)                      Premises and Equipment

 

**Componentsof premises and equipment at December 31, 2003 and 2002 were as follows:**

 
| **(Dollars in thousands)**                     |   | **2003** |   | **2002** |   |
|------------------------------------------------|--------|----------|--------|----------|--------|
| Land                                           |   | $        | 1,024  |     | $      | 197 |   |
| Building                                       |   | 1,472    |   | 789      |   |
| Furniture and equipment                        |   | 5,322    |   | 4,304    |   |
| Leasehold improvements                         |   | 2,618    |   | 2,351    |   |
| Total cost                                     |   | 10,436   |   | 7,641    |   |
| Less accumulated depreciation and amortization |   | 3,729    |   | 2,699    |   |
| Premises and equipment, net                    |   | $        | 6,707  |     | $      | 4,942 |   |

** **

**Depreciationexpense for the years ended December 31, 2003, 2002 and 2001 was $1.0 million,$736,000 and $804,000, respectively.**

** **

**TheCompany has entered into leases for office space over various terms.  The leases are subject to annual increasesas well as allocations of real estate taxes and certain operating expenses.**

** **

**Minimumfuture rental payments under the noncancelable operating leases, as ofDecember 31, 2003 for each of the next five years and in the aggregate,are as follows:**

 

64

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*(Dollars in thousands)*

 

| **Year ending December 31,** |   | **Amount** |   |
|------------------------------|--------|------------|--------|
| 2004                         |   | $          | 1,962  |   |
| 2005                         |   | 2,050      |   |
| 2006                         |   | 2,041      |   |
| 2007                         |   | 2,151      |   |
| 2008                         |   | 1,931      |   |
| Thereafter                   |   | 2,265      |   |
|                         |   | $          | 12,400 |   |

 

**Thetotal rent expense was $1.9 million, $1.3 million and $1.3 million in 2003,2002 and 2001, respectively.**

** **

The Company has entered into contracts assublessor for excess office space. Future minimum lease payment receivablesunder noncancellable leasing arrangements as of December 31, 2003 for each ofthe next five years and in the aggregate, are as follows:

 

*(Dollars in thousands)*

 
| **Year ending December 31,** |   | **Amount** |   |
|------------------------------|--------|------------|--------|
| 2004                         |   | $          | 322    |   |
| 2005                         |   | 289        |   |
| 2006                         |   | 274        |   |
| 2007                         |   | 181        |   |
| 2008                         |   | 142        |   |
| Thereafter                   |   | 570        |   |
|                         |   | $          | 1,778  |   |

 

**Thetotal rent income was $453,000, $409,000 and $110,000 in 2003, 2002 and 2001,respectively.**

 

(6)                      Deposits

 

**Depositsconsist of the following at December 31, 2003 and 2002:**

 
| **(Dollars in thousands)**         |   | **2003** |    | **2002** |   |
|------------------------------------|--------|----------|---------|----------|--------|
| Demand deposits                    |   | $        | 70,998  |     | $      | 72,962 |   |
| Interest checking                  |   | 152,656  |    | 146,041  |   |
| Money market and statement savings |   | 30,139   |    | 31,078   |   |
| Certificates of deposit            |   | 220,336  |    | 173,398  |   |
|                               |   | $        | 474,129 |     | $      | 423,479 |   |

 

65

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Interest expenseby deposit categories is as follows:

 
| **(Dollars in thousands)**         |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Interest checking                  |   | $        | 2,375  |     | $      | 3,073    |   | $ | 370 |   |
| Money market and statement savings |   | 243      |   | 577      |   | 869      |   |
| Certificates of deposit            |   | 6,038    |   | 5,714    |   | 5,788    |   |
|                               |   | $        | 8,656  |     | $      | 9,364    |   | $ | 7,027 |   |

 

**Theaggregate amount of time deposits, each with a minimum denomination of $100,000was $103.6 million and $80.2 million at December 31, 2003 and 2002,respectively.**

** **

**AtDecember 31, 2003, the scheduled maturities of certificates of deposit areas follows:**

 
| **(Dollars in thousands)** |   |   |    |
|----------------------------|--------|--------|---------|
| 2004                       |   | $      | 136,838 |   |
| 2005                       |   | 39,685 |    |
| 2006                       |   | 14,491 |    |
| 2007                       |   | 16,691 |    |
| 2008 and thereafter        |   | 12,631 |    |
|                       |   | $      | 220,336 |   |

 

(7)                    Other Borrowed Funds

 

**TheCompany has fixed rate advances from the Federal Home Loan Bank of Atlanta(FHLB) of $44.0 million at December 31, 2003. These advances mature through 2008 and have interest rates ranging from1.31% to 2.81%.  At December 31, 2002,the Company had $2.0 million in advances from the Federal Home Loan Bank ofAtlanta with maturities through 2003 and interest rates ranging from 1.96% to3.70%.**

** **

**TheCompany has a floating rate advance from the Federal Home Loan Bank of Atlantaof $5.0 million at December 31, 2003, which matures in 2004.  The floating rate is based on the threemonth London Interbank Offer Rate (LIBOR). At December 31, 2003, the interest rate on the floating rate advance was1.23%.  The Company had no floating rateadvances at December 31, 2002.**

** **

The contractual maturities of the fixed and floatingrate advances are as follows:

 

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*(Dollars in thousands)*

 
| **At December 31, 2003**             |   |
|--------------------------------------|--------|
| **Type of Advance**                  |   | **Interest  Rate** |   | **Term of  Advance** |   | **Date Due** |   | **Amount  Outstanding** |   |
| Fixed Rate Credit                    |   | 1.31 | % | 5 months |   | Jan-04 |   | $ | 2,000 |   |
| Fixed Rate Credit                    |   | 1.63 | % | 12  months |   | Jan-04 |   | 2,000 |   |
| Fixed Rate Credit                    |   | 1.72 | % | 12  months |   | Jan-04 |   | 2,000 |   |
| Fixed Rate Credit                    |   | 1.36 | % | 6  months |   | Feb-04 |   | 2,000 |   |
| Fixed Rate Credit                    |   | 1.54 | % | 12  months |   | Mar-04 |   | 1,000 |   |
| Fixed Rate Credit                    |   | 1.65 | % | 12  months |   | Mar-04 |   | 2,000 |   |
| Fixed Rate Credit                    |   | 1.81 | % | 18  months |   | Jul-04 |   | 2,000 |   |
| Fixed Rate Credit                    |   | 1.96 | % | 18  months |   | Jul-04 |   | 2,000 |   |
| Fixed Rate Credit                    |   | 1.77 | % | 18  months |   | Sep-04 |   | 1,000 |   |
| Fixed Rate Credit                    |   | 1.86 | % | 18  months |   | Sep-04 |   | 1,000 |   |
| Adjustable Rate Credit               |   | 1.23 | % | 12  months |   | Dec-04 |   | 5,000 |   |
| Fixed Rate Credit                    |   | 1.82 | % | 24  months |   | Mar-05 |   | 1,000 |   |
| Fixed Rate Credit                    |   | 2.33 | % | 36  months |   | Mar-06 |   | 1,000 |   |
| Fixed Rate Credit                    |   | 2.07 | % | 36  months |   | Jul-06 |   | 6,250 |   |
| Fixed Rate Credit                    |   | 2.81 | % | 48  months |   | Mar-07 |   | 1,000 |   |
| Fixed Rate Credit                    |   | 2.63 | % | 48  months |   | Jul-07 |   | 6,250 |   |
| Principal Reducing Fixed Rate Credit |   | 2.29 | % | 60  months |   | Jul-08 |   | 11,458 |   |
| Total advances from FHLB             |   | 1.98 | % |   |   |   |   | $ | 48,958 |   |

 
| **At December 31, 2002** |   |
|--------------------------|--------|
| **Type of Advance**      |   | **Interest  Rate** |   | **Term of  Advance** |   | **Date Due** |   | **Amount  Outstanding** |   |
| Fixed Rate Credit        |   | 1.96 | % | 6  months |   | Apr-03 |   | $ | 1,000 |   |
| Fixed Rate Credit        |   | 3.70 | % | 24  months |   | Sep-03 |   | 1,000 |   |
| Total advances from FHLB |   | 2.83 | % |   |   |   |   | $ | 2,000 |   |

 

The average balances of FHLB advances for theyears ended December 31, 2003 and 2002 were $33.5 million and $5.6 million,respectively. The maximum amount outstanding at any month-end during the yearsended December 31, 2003 and 2002 was $56.8 million and $9.8 million, respectively.  Total interest expense on FHLB advances forthe years ended December 31, 2003, 2002 and 2001 was $654,000, $222,000,and $448,000, respectively.

 

**Securitiessold under agreements to repurchase, which are classified as securedborrowings, generally mature within one to four days from the transactiondate.  Securities sold under agreementsto repurchase are reflected at the amount of cash received in connection withthe transaction.  The Company isrequired to provide additional collateral based on the fair value of theunderlying securities.**

 

**AtDecember 31, 2003 and 2002 the Company had repurchase agreements of $25.5million and $0, respectively.  Theinterest rate of the repurchase agreements at December 31, 2003 was 0.75%.  The average balances of the repurchaseagreements for 2003 and 2002 were $9.2 million and $0, respectively, and themaximum amount outstanding at any month-end**

 

67

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**during2003 and 2002 were $26.1 million and $1.6 million, respectively.  Interest expense on repurchase agreementsfor 2003, 2002 and 2001 was $72,000, $0, $25,000, respectively.**

 

Occasionally, theCompany purchases fed funds.  AtDecember 31, 2003 and 2002, the Company had no outstanding purchases in fedfunds.  Interest expense related to fedfunds purchased as of December 31, 2003 was $47,000.  There was no interest expense as of December 31, 2002 and 2001.

 

(8)                      Preferred Stock

 

In connection with theacquisition of Heritage Bancorp, Inc. on September 1, 2000, the Company issued1,411,268 shares of 7.25% Cumulative Convertible Preferred Stock, SeriesA.  Shares of the Preferred Stockoutstanding at December 31, 2003 and 2002 were 1,364,062 and 1,364,684,respectively. The Series A Preferred Stock has a par value of $1.00 per shareand a liquidation preference of $5.00 per share.  It is automatically converted into the Company’s common stock ifthe common stock trades at a price above $8.65 for 20 consecutive trading daysbeginning at anytime on or after March 1, 2004.  Dividends on the Series A Preferred Stock are payable quarterlyfor a cumulative annual dividend of $0.3625 or 7.25% of the $5.00 liquidationamount, before any dividend is paid on any Cardinal common stock.  Holders of Series A Preferred Stock have theright to convert one share of Series A Preferred Stock for 0.75 shares ofCardinal common stock at any time. Holders of Series A Preferred Stock are not entitled to receive noticeof, or to participate in, or to vote on any matter at any meeting of theshareholders, except to the extent that they are afforded a vote by the laws ofthe Commonwealth of Virginia in existence at the time any matter requiring sucha vote shall arise.  Notwithstanding thelack of voting rights, under Sections 13.1-707 and 708 of the Virginia StockCorporation Act, the holders of the Series A Preferred Stock are entitled tonotice of any meeting of the shareholders considering an amendment to ourArticles of Incorporation relating to any of the matters described in Section13.1-708 of the Virginia Stock Corporation Act and to vote as a class.

 

(9)                      Income Taxes

 

**TheCompany and its subsidiaries file consolidated tax returns on a calendar-yearbasis.  The Company recorded and incometax benefit of $3.5 million during the year ended December 31, 2003 and had noprovision for current and deferred income taxes for the years endedDecember 31, 2002 and 2001.**

** **

**Theprovision for income tax expense (benefit) is reconciled to the amount computedby applying the federal corporate tax rate to income before taxes and is asfollows:**

 
| **(Dollars in thousands)**                     |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Income tax (benefit) at federal corporate rate |   | $        | 900    |     | $      | (180     | )      | $ | (4,326 | ) |
| Nondeductible expenses                         |   | 7        |   | 7        |   | 2,998    |   |
| Change in valuation allowance                  |   | (4,415   | )      | 173      |   | 1,328    |   |
|                                           |   | $        | (3,508 | )        | $      | —   |   | $ | — |   |

 

68

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**Thetax benefits of temporary differences between the financial reporting basis andincome tax basis of assets and liabilities relate to the following:**

 
| **(Dollars in thousands)**                                             |   | **2003** |   | **2002** |   |
|------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets:                                                   |   |     |   |     |   |
| Bad debts                                                              |   | $        | 1,391  |     | $      | 1,047 |   |
| Organization and other costs                                           |   | —   |   | 19       |   |
| Net operating loss carryforwards                                       |   | 3,606    |   | 4,401    |   |
| Unrealized (gains) losses on investment securities  available-for-sale |   | 260      |   | (797     | )      |
| Other                                                                  |   | 126      |   | 157      |   |
| Total gross deferred assets                                            |   | 5,383    |   | 4,827    |   |
| Less valuation allowance                                               |   | (668     | )      | (4,553   | )      |
| Net deferred tax assets                                                |   | 4,715    |   | 274      |   |
| Deferred tax liabilities:                                              |   |     |   |     |   |
| Prepaid expenses                                                       |   | (51      | )      | (19      | )      |
| Depreciation                                                           |   | (121     | )      | (134     | )      |
| Loan origination costs                                                 |   | (70      | )      | (121     | )      |
| Total gross deferred tax liabilities                                   |   | (242     | )      | (274     | )      |
|                                                                   |   |     |   |     |   |
| Net deferred tax asset                                                 |   | $        | 4,473  |     | $      | — |   |

 

Deferred tax assets and liabilities arerecognized for the tax effects of differing carrying values of assets andliabilities for tax and financial statement purposes that will reverse infuture periods.  When substantialuncertainty exists concerning the recoverability of a deferred tax asset, thecarrying value of the asset is reduced by a valuation allowance.  Avaluation allowance in the amount of $668,000 at December 31, 2003 hasbeen established for deferred tax assets. This valuation allowance relates primarily to the state portion of thenet operating losses for the Parent Company and Cardinal Wealth Services, Inc.as realization is dependent upon generating future taxable income within thoseentities.

 

**TheCompany has net operating loss carryforwards of approximately $9.2 million atDecember 31, 2003, which are available to offset tax payments on futuretaxable income.  The Company’s netoperating loss carryforwards expire as follows:  $1.4 million in 2019, $5.1 million in 2020, and $2.7 million in2021.**

 

(10)                Regulatory Matters

 

**TheCompany’s banking subsidiary, Cardinal Bank, N.A. (the “Bank”), as a nationalbank, is subject to the dividend restrictions established by the Comptroller ofthe Currency.  Under such restrictions,the Bank may not, without the prior approval of the Comptroller of**

 

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**theCurrency, declare dividends in excess of the sum of the current year’s earnings(as defined) plus the retained earnings (as defined) from the prior twoyears.  At December 31, 2003, therewere no earnings against which dividends could be paid.**

** **

**TheBank is required to maintain a minimum average reserve balance with the FederalReserve Bank.  The average amount of therequired reserve was $1.9 million for 2003. As members of the Federal Reserve Bank system, the Bank is required tosubscribe to shares of $100 par value Federal Reserve Bank stock equal to 6percent of the Bank’s capital and surplus. The Bank is required to pay for one-half of the subscription.  The remaining amount is subject to call whendeemed necessary by the Board of Governors of the Federal Reserve.**

** **

**TheFederal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”)requires the regulators to stratify institutions into five quality tiers basedupon their relative capital strengths and to increase progressively the degreeof regulation over the weaker institutions, limits the pass through depositinsurance treatment of certain types of accounts, adopts a “truth in savings”program, calls for the adoption of risk-based premiums on deposit insurance andrequires the Bank to observe insider credit underwriting products no lessstrict than those applied to comparable noninsider transactions.**

** **

**AtDecember 31, 2003 and 2002, the Company and the Bank met all regulatorycapital requirements.  The key measuresof capital are: (1) total capital (Tier I capital plus the allowance forloan losses up to certain limitations) as a percent of total risk-weightedassets, (2) Tier I capital (as defined) as a percent of totalrisk-weighted assets (as defined), and (3) Tier I capital (as defined) asa percent of total assets (as defined).**

 

**At December 31, 2003**

*(Dollars in thousands)*

 
|                                   |   | **Actual** |   | **For Capital  Adequacy Purposes** |   | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** |   |
|----------------------------------------|--------|------------|--------|------------------------------------|--------|-------------------------------------------------------------------------|--------|
|                                   |   | **Amount** |   | **Ratio**                          |   | **Amount**                                                              |   |   |   | **Ratio** |   | **Amount** |   |   |   | **Ratio** |   |
| Total capital to risk weighted assets  |   | $          | 90,239 |                               | 20.66  | %                                                                       | $      | 34,951 |   | > |   | 8.00 | % | $ | 43,688 |   | > |   | 10.00 | % |
| Tier I capital to risk weighted assets |   | 85,896     |   | 19.66                              | %      | 17,475                                                                  |   | > |   | 4.00 | % | 26,213 |   | > |   | 6.00 | % |
| Tier I capital to average assets       |   | 85,896     |   | 15.45                              | %      | 23,365                                                                  |   | > |   | 4.00 | % | 29,206 |   | > |   | 5.00 | % |
|                                        |        |            |        |                                    |        |                                                                         |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**At December 31, 2002**

*(Dollars in thousands)*

 
|                                   |   | **Actual** |   | **For Capital  Adequacy Purposes** |   | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** |   |
|----------------------------------------|--------|------------|--------|------------------------------------|--------|-------------------------------------------------------------------------|--------|
|                                   |   | **Amount** |   | **Ratio**                          |   | **Amount**                                                              |   |   |   | **Ratio** |   | **Amount** |   |   |   | **Ratio** |   |
| Total capital to risk weighted assets  |   | $          | 41,093 |                               | 13.35  | %                                                                       | $      | 24,625 |   | > |   | 8.00 | % | $ | 30,781 |   | > |   | 10.00 | % |
| Tier I capital to risk weighted assets |   | 37,721     |   | 12.25                              | %      | 12,313                                                                  |   | > |   | 4.00 | % | 18,469 |   | > |   | 6.00 | % |
| Tier I capital to average assets       |   | 37,721     |   | 8.97                               | %      | 18,330                                                                  |   | > |   | 4.00 | % | 15,391 |   | > |   | 5.00 | % |
|                                        |        |            |        |                                    |        |                                                                         |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

(11)                Related-Party Transactions

 

**Officers,directors, employees and their related business interests are loan customers inthe ordinary course of business.  Inmanagement’s opinion, these loans are made on**

 

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**substantiallythe same terms, including interest rates and collateral, as those prevailing atthe time for comparable loans with other persons and do not involve more thannormal risk of collectibility or present other unfavorable features.**

** **

**Analysisof activity for loans to related parties is as follows:**

 
| **(Dollars in thousands)**  |   | **2003** |   | **2002** |   |
|-----------------------------|--------|----------|--------|----------|--------|
| Balance, beginning of year  |   | $        | 4,752  |     | $      | 2,727 |   |
| New loans                   |   | 2,242    |   | 2,177    |   |
| Loans paid off or paid down |   | (2,503   | )      | (152     | )      |
| Balance, end of year        |   | $        | 4,491  |     | $      | 4,752 |   |

 

(12)                Earnings (Loss) Per Common Share

 

The following is the calculation of basic and diluted earnings (loss)per common share.  Because the Companyhad net losses in 2002 and 2001, outstanding stock options had an anti-dilutiveeffect and, therefore, were excluded from the loss per common share calculationfor those years.

 

At December 31, 2003, the dilutive potential common shares resultingfrom outstanding stock options added to the weighted average shares for thediluted earnings per common share calculation were 227,000.  At December 31, 2003, 9,000 outstandingstock options were excluded from the weighted average shares outstanding forthe diluted earnings per share calculation as these stock options have exerciseprices that were greater than the average market price of the Company’s commonstock for the year ended December 31, 2003.

 
| **(Dollars and shares in thousands)**    |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net income (loss)                        |   | $        | 6,154  |     | $      | (529     | )      | $ | (12,724 | ) |
| Dividends to preferred shareholders      |   | 495      |   | 495      |   | 503      |   |
| Net income (loss) to common shareholders |   | $        | 5,659  |     | $      | (1,024   | )      | $ | (13,227 | ) |
| Weighted average shares for basic        |   | 10,218   |   | 7,949    |   | 4,258    |   |
| Weighted average shares for diluted      |   | 10,445   |   | 7,949    |   | 4,258    |   |
| Basic earnings (loss) per common share   |   | $        | 0.55   |     | $      | (0.13    | )      | $ | (3.11 | ) |
| Diluted earnings (loss) per common share |   | $        | 0.54   |     | $      | (0.13    | )      | $ | (3.11 | ) |

 

(13)                Employee Benefit Plan

 

**TheCompany established a 401(k) plan in January 1998 for all eligibleemployees.  The Company began to match aportion of employee contributions beginning January 1, 1999.  The Company’s match for December 31, 2003,2002 and 2001 was $106,000, $102,000, and $118,000, respectively.**

 

71

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(14)                Director and Employee Stock Compensation Plans

 

**In1998, the Company adopted a stock option plan (the ”Plan”) pursuant towhich the Company may grant stock options to employees and members of theCompany’s and its’ subsidiaries’ Boards of Directors.  625,000 options to purchase shares of the Company’s common stockare authorized under this plan as of December 31, 2003.**

 

**In1999, the Company granted stock awards to an employee.  These awards became fully vested in 2001.For the years ended December 31, 2003, 2002 and 2001, the Company recognized$0, $0, and $6,000, respectively, in compensation expense related to the stockawards.**

** **

During 2002, theshareholders approved the Company’s 2002 Equity Compensation Plan (the “EquityPlan”).  The Equity Plan authorizes thegranting of options, which may either be incentive stock options, non-qualifiedstock options, stock appreciation rights, restricted stock awards, phantomstock awards and performance share awards to directors, eligible officers andkey employees of the Company.  TheEquity Plan authorizes the issuance of options and other equity instrumentsequivalent to 700,000 shares of the outstanding shares of common stock plusshares of common stock issuable upon conversion of the Company’s outstandingSeries A Preferred Stock.

** **

**Stockoptions are granted with an exercise price equal to the stock’s fair marketvalue at the date of grant.  Directorstock options have 10-year terms and vest and become fully exercisableimmediately.  Certain employee stockoptions have 10-year terms and vest and become fully exercisable after 3 years.Other employee stock options have 10-year terms and vest and become fullyexercisable in 20% increments beginning as of the grant date.  Stock options granted to new employees ofthe Company have 10-year terms and vest and become fully exercisable in 20%increments beginning after their first year of vesting.**

 

72

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**Stockoption activity during the years indicated is as follows:**

 
|                         |   | **Number of  Shares** |   | **Weighted  Average  Exercise  Price** |   |
|------------------------------|--------|-----------------------|--------|----------------------------------------|--------|
| Balance at December 31, 2000 |   | 325,212               |   | $                                      | 5.74   |   |
|                         |   |                  |   |                                   |   |   |
| Granted                      |   | 130,740               |   | 4.07                                   |   |
| Exercised                    |   | (2,809                | )      | 3.75                                   |   |
| Forfeited                    |   | (85,115               | )      | 5.77                                   |   |
| Expired                      |   | —                |   | —                                 |   |
|                         |   |                  |   |                                   |   |
| Balance at December 31, 2001 |   | 368,028               |   | $                                      | 5.23   |   |
|                         |   |                  |   |                                   |   |   |
| Granted                      |   | 265,530               |   | 3.27                                   |   |
| Exercised                    |   | —                |   | —                                 |   |
| Forfeited                    |   | (90,665               | )      | 5.48                                   |   |
| Expired                      |   | —                |   | —                                 |   |
|                         |   |                  |   |                                   |   |
| Balance at December 31, 2002 |   | 542,893               |   | $                                      | 4.22   |   |
|                         |   |                  |   |                                   |   |   |
| Granted                      |   | 376,000               |   | 5.07                                   |   |
| Exercised                    |   | (32,523               | )      | 4.44                                   |   |
| Forfeited                    |   | (38,933               | )      | 4.90                                   |   |
| Expired                      |   | —                |   | —                                 |   |
|                         |   |                  |   |                                   |   |
| Balance at December 31, 2003 |   | 847,437               |   | $                                      | 4.57   |   |

** **

**Informationpertaining to stock options outstanding at December 31, 2003 and 2002 is asfollows:**

 

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**At December 31, 2003**

 
|                          |   | **Options  Outstanding** |   | **Options  Exercisable**        |   |
|-------------------------------|--------|--------------------------|--------|---------------------------------|--------|
|                          |   |                     |   | **Weighed  Average**            |   |   |   | **Weighted  Average  Exercise  Price** |   |
| **Range of  Exercise Prices** |   | **Number  Outstanding**  |   | **Remaining  Contractual Life** |   | **Exercise  Price** |   | **Number  Exercisable** |   |   |
|                          |   |                     |   |                            |   |   |   |   |   |   |   |
| $  2.41 - $3.56               |   | 305,999                  |   | 7.8 years                       |   | $ | 3.27 |   | 163,455 |   | $ | 3.36 |   |
| $  3.95 - $5.50               |   | 415,241                  |   | 8.8 years                       |   | 4.86 |   | 128,211 |   | 4.83 |   |
| $  6.38 - $7.25               |   | 126,197                  |   | 6.1 years                       |   | 6.79 |   | 103,447 |   | 6.77 |   |
| Outstanding at year end       |   | 847,437                  |   | 8.0 years                       |   | $ | 4.57 |   | 395,113 |   | $ | 4.73 |   |
|                               |        |                          |        |                                 |        |  |  |  |  |  |  |  |  |  |

 

**At December 31, 2002**

 
|                          |   | **Options  Outstanding** |   | **Options  Exercisable**        |   |
|-------------------------------|--------|--------------------------|--------|---------------------------------|--------|
|                          |   |                     |   | **Weighed  Average**            |   |   |   | **Weighted Average  Exercise  Price** |   |
| **Range of  Exercise Prices** |   | **Number  Outstanding**  |   | **Remaining  Contractual Life** |   | **Exercise  Price** |   | **Number  Exercisable** |   |   |
|                          |   |                     |   |                            |   |   |   |   |   |   |   |
| $  2.41 - $3.56               |   | 333,365                  |   | 8.4 years                       |   | $ | 3.27 |   | 143,585 |   | $ | 3.29 |   |
| $  3.95 - $5.50               |   | 103,690                  |   | 7.9 years                       |   | 4.68 |   | 30,211 |   | 4.22 |   |
| $  6.38 - $7.00               |   | 105,088                  |   | 6.4 years                       |   | 6.77 |   | 105,088 |   | 6.77 |   |
| $  10.00 - $10.00             |   | 750                      |   | 5.9 years                       |   | 10.00 |   | 750 |   | 10.00 |   |
| Outstanding at year end       |   | 542,893                  |   | 8.0 years                       |   | $ | 4.22 |   | 279,634 |   | $ | 4.71 |   |
|                               |        |                          |        |                                 |        |  |  |  |  |  |  |  |  |  |

 

At December 31, 2003 and 2002,additional shares available for grant under both stock option plans were477,563 and 72,039, respectively.

 

(15)                Segment Reporting

 

The Company operates and reports in twobusiness segments, commercial banking and investment advisory services.  The commercial banking segment includes bothcommercial and consumer lending and provides customers such products ascommercial loans, real estate loans, and other business financing and consumerloans.  In addition, this segment alsoprovides customers with several choices of deposit products including demanddeposit accounts, savings accounts and certificates of deposit.  The investment advisory services segmentprovides advisory services to businesses and individuals including financialplanning and retirement/estate planning.

** **

**Informationabout reportable segments, and reconciliation of such information to theconsolidated financial statements as of and for the years ended December 31,2003, 2002 and 2001 follows:**

 

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*(Dollars in thousands)*

 
|                      |   | **December  31, 2003**  |    |
|---------------------------|--------|-------------------------|---------|
|                      |   | **Commercial  Banking** |    | **Investment  Advisory** |   | **Other** |   | **Intersegment  Elimination** |   | **Consolidated** |   |
| Net interest income       |   | $                       | 15,077  |   | $ | — |   | $ | 96 |   | $ | — |   | $ | 15,173 |   |
| Provision for loan losses |   | 1,001                   |    | — |   | — |   | — |   | 1,001 |   |
| Non-interest income       |   | 2,954                   |    | 843 |   | 32 |   | — |   | 3,829 |   |
| Non-interest expense      |   | 13,265                  |    | 820 |   | 1,270 |   | — |   | 15,355 |   |
| Income tax benefit        |   | (464                    | )       | (443 | ) | (2,601 | ) | — |   | (3,508 | ) |
| Net income                |   | $                       | 4,229   |   | $ | 466 |   | $ | 1,459 |   | $ | — |   | $ | 6,154 |   |
|                      |   |                    |    |   |   |   |   |   |   |   |   |
| Total assets              |   | $                       | 630,415 |   | $ | 776 |   | $ | 85,960 |   | $ | (80,903 | ) | $ | 636,248 |   |

 
|                      |   | **December  31, 2002**  |    |
|---------------------------|--------|-------------------------|---------|
|                      |   | **Commercial  Banking** |    | **Investment  Advisory** |   | **Other** |   | **Intersegment  Elimination** |   | **Consolidated** |   |
| Net interest income       |   | $                       | 10,575  |   | $ | — |   | $ | 81 |   | $ | — |   | $ | 10,656 |   |
| Provision for loan losses |   | 444                     |    | — |   | — |   | — |   | 444 |   |
| Non-interest income       |   | 1,848                   |    | 942 |   | 74 |   | — |   | 2,864 |   |
| Non-interest expense      |   | 11,995                  |    | 1,147 |   | 463 |   | — |   | 13,605 |   |
| Net loss                  |   | $                       | (16     | ) | $ | (205 | ) | $ | (308 | ) | $ | — |   | $ | (529 | ) |
|                      |   |                    |    |   |   |   |   |   |   |   |   |
| Total assets              |   | $                       | 483,135 |   | $ | 274 |   | $ | 41,159 |   | $ | (38,245 | ) | $ | 486,323 |   |

 

 
|                      |   | **December  31, 2001**  |    |
|---------------------------|--------|-------------------------|---------|
|                      |   | **Commercial  Banking** |    | **Investment  Advisory** |   | **Intersegment  Other** |   | **Elimination** |   | **Consolidated** |   |
| Net interest income       |   | $                       | 9,051   |   | $ | — |   | $ | 26 |   | $ | — |   | $ | 9,077 |   |
| Provision for loan losses |   | 1,202                   |    | — |   | — |   | — |   | 1,202 |   |
| Non-interest income       |   | 1,167                   |    | 1,947 |   | 43 |   | — |   | 3,157 |   |
| Non-interest expense      |   | 19,177                  |    | 2,034 |   | 2,545 |   | — |   | 23,756 |   |
| Net loss                  |   | $                       | (10,161 | ) | $ | (87 | ) | $ | (2,476 | ) | $ | — |   | $ | (12,724 | ) |
|                      |   |                    |    |   |   |   |   |   |   |   |   |
| Total assets              |   | $                       | 277,930 |   | $ | 420 |   | $ | 23,228 |   | $ | (21,994 | ) | $ | 279,584 |   |

 

**TheCompany does not have operating segments other than those reported.  Parent Company financial information isincluded in the Other category and represents the overhead function rather thanan operating segment.**

 

(16)                Financial Instruments with Off BalanceSheet Risk

 

**TheCompany is a party to financial instruments with off-balance-sheet risk in thenormal course of business to meet the financing needs of its customers.  These financial instruments includecommitments to extend credit and standby letters of credit and**

 

75

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**financialguarantees.  Commitments to extendcredit are agreements to lend to a customer so long as there is no violation ofany condition established in the contract. Commitments usually have fixed expiration dates up to one year or othertermination clauses and may require payment of a fee.  Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements.**

** **

**Standbyletters of credit are conditional commitments issued by the Company toguarantee the performance of the contractual obligations by a customer to athird party.  The majority of theseguarantees extend until satisfactory completion of the customer’s contractualobligations.  All standby letters ofcredit outstanding at December 31, 2003 are collateralized.**

** **

**Thoseinstruments represent obligations of the Company to extend credit or guaranteeborrowings; and therefore, are not recorded on the consolidated statements offinancial condition.  The rates andterms of these instruments are competitive with others in the market in whichthe Company operates.  Almost all ofthese instruments as of December 31, 2003 have floating rates, therebysignificantly mitigating the market risk.**

** **

**Thoseinstruments may involve, to varying degrees, elements of credit and interestrate risk in excess of the amount recognized in the consolidated statements offinancial condition.  Credit risk isdefined as the possibility of sustaining a loss because the other parties to afinancial instrument fail to perform in accordance with the terms of thecontract.  The Company’s maximumexposure to credit loss under standby letters of credit and commitments toextend credit is represented by the contractual amounts of those instruments.**

 

(Dollars in thousands)

 
|                                                                           |   | **2003** |    | **2002** |   |
|--------------------------------------------------------------------------------|--------|----------|---------|----------|--------|
| Financial instruments whose contract amounts  represent potential credit risk: |   |     |    |     |   |
| Commitments to extend credit                                                   |   | $        | 111,182 |     | $      | 66,767 |   |
| Standby letters of credit                                                      |   | 3,330    |    | 1,610    |   |
|                                                                                |        |          |         |          |        |  |  |

 

The Company hadrecorded no liability associated with standby letters of credit at December 31,2003 as such amounts were immaterial.

 

**TheCompany uses the same credit policies in making commitments and conditionalobligations as it does for on-balance-sheet instruments.  The Company evaluates each customer’screditworthiness on a case-by-case basis and requires collateral to supportfinancial instruments when deemed necessary. The amount of collateral obtained upon extension of credit is based onmanagement’s evaluation of the counterparty. Collateral held varies but may include deposits held by the Company,marketable securities, accounts receivable, inventory, property, plant andequipment, and income-producing commercial properties.**

 

76

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(17)                Disclosures of Fair Value of Financial Instruments

 

**Theassumptions used and the estimates disclosed represent management’s bestjudgment of appropriate valuation methods. These estimates are based on pertinent information available tomanagement at the valuation date.  Incertain cases, fair values are not subject to precise quantification orverification and may change as economic and market factors and management’sevaluation of those factors change.**

** **

**Althoughmanagement uses its best judgment in estimating the fair value of thesefinancial instruments, there are inherent limitations in any estimationtechnique.  Therefore, these fair valueestimates are not necessarily indicative of the amounts the Company wouldrealize in a market transaction. Because of the wide range of valuation techniques and the numerousestimates which must be made, it may be difficult to make reasonablecomparisons of the Company’s fair value information to that of other financialinstitutions.  It is important that themany uncertainties discussed above be considered when using the estimated fairvalue disclosures and that, because of these uncertainties, the aggregate fairvalue amount should in no way be construed as representative of the underlyingvalue of the Company.**

** **

***Fair Value ofFinancial Instruments***

** **

**Thefollowing summarizes the significant methodologies and assumptions used inestimating the fair values presented in the accompanying table.**

** **

***Cashand Cash Equivalents***

** **

**Thecarrying amount of cash and cash equivalents is used as a reasonable estimateof fair value.**

** **

***InvestmentSecurities and Other Investments***

** **

**Fairvalues for investment securities are based on quoted market prices or pricesquoted for similar financial instruments. Fair value for other investments is estimated at their cost since noactive trading markets exist.**

** **

*Loans Receivable, Net*

** **

**Inorder to determine the fair market value for loans receivable, the loan portfoliowas segmented based on loan type, credit quality and maturities.  For certain variable rate loans with nosignificant credit concerns and frequent repricings, estimated fair values arebased on current carrying amounts.  Thefair values of other loans are estimated using discounted cash flow analyses,using interest rates currently being offered for loans with similar terms toborrowers of similar credit quality.**

** **

***Deposits***

** **

**Thefair values disclosed for demand deposits are, by definition, equal to theamount payable on demand at the reporting date (that is, their carryingamounts).  The carrying**

 

77

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**amountsof variable rate, fixed-term money market accounts and certificates of deposit(CDs) approximate their fair value at the reporting date.  Fair values for fixed-rate CDs are estimatedusing a discounted cash flow calculation that applies interest rates currentlybeing offered on CDs to a schedule of aggregated expected monthly maturities ontime deposits.**

** **

***OtherBorrowed Funds***

 

The fair value of other borrowed funds is estimatedusing a discounted cash flow calculation that applies interest rates currentlyavailable with similar terms.

*** ***

***Commitments***

** **

**Thefair value of these financial instruments is based on the credit quality andrelationship, fees, interest rates, probability of funding, compensatingbalance and other covenants or requirements. These commitments generally have fixed expiration dates expiring withinone year.  Many commitments are expectedto, and typically do, expire without being drawn upon.  The rates and terms of these instruments arecompetitive with others in the market in which the Company operates.  The carrying amounts are reasonableestimates of the fair value of these financial instruments.  The carrying amounts of these instrumentsare zero at December 31, 2003 and 2002.**

** **

***AccruedInterest***

** **

**Thecarrying amounts of accrued interest approximate their fair values.**

 

**Fairvalue of financial instruments as of December 31, 2003 and 2002:**

 
|                                        |   | **December 31, 2003** |   |
|---------------------------------------------|--------|-----------------------|--------|
| **(Dollars in thousands)**                  |   | **Carrying  Amount**  |   | **Estimated  Fair Value** |   |
| Financial assets:                           |   |                  |   |   |   |
| Cash and cash equivalents                   |   | $                     | 13,083 |   | $ | 13,083 |   |
| Investment securities and other investments |   | 277,131               |   | 275,909 |   |
| Loans receivable, net                       |   | 331,658               |   | 327,087 |   |
| Accrued interest receivable                 |   | 2,082                 |   | 2,082 |   |
| Financial liabilities:                      |   |                  |   |   |   |
| Demand deposits                             |   | $                     | 70,998 |   | $ | 70,998 |   |
| Interest checking                           |   | 152,656               |   | 152,656 |   |
| Money market and statement savings          |   | 30,139                |   | 30,139 |   |
| Certificates of deposit                     |   | 220,336               |   | 227,871 |   |
| Other borrowed funds                        |   | 74,457                |   | 73,967 |   |
| Accrued interest payable                    |   | 164                   |   | 164 |   |

 

78

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|                                        |   | **December 31, 2002** |   |
|---------------------------------------------|--------|-----------------------|--------|
| **(Dollars in thousands)**                  |   | **Carrying  Amount**  |   | **Estimated  Fair Value** |   |
| Financial assets:                           |   |                  |   |   |   |
| Cash and cash equivalents                   |   | $                     | 63,371 |   | $ | 63,371 |   |
| Investment securities and other investments |   | 165,280               |   | 165,280 |   |
| Loans receivable, net                       |   | 245,734               |   | 257,480 |   |
| Accrued interest receivable                 |   | 1,523                 |   | 1,523 |   |
| Financial liabilities:                      |   |                  |   |   |   |
| Demand deposits                             |   | $                     | 72,962 |   | $ | 72,962 |   |
| Interest checking                           |   | 146,041               |   | 146,041 |   |
| Money market and statement savings          |   | 31,078                |   | 31,078 |   |
| Certificates of deposit                     |   | 173,398               |   | 178,360 |   |
| Other borrowed funds                        |   | 2,000                 |   | 2,000 |   |
| Accrued interest payable                    |   | 107                   |   | 107 |   |

 

(18)                Parent Company Only FinancialStatements

 

The Cardinal FinancialCorporation (Parent Company only) condensed financial statements are asfollows:

 

PARENT COMPANY ONLY CONDENSED STATEMENTS OF CONDITION

 

December 31, 2003 and 2002

 

(Dollars in thousands)

 
|                                            |   | **2003** |       | **2002** |       |
|-------------------------------------------------|--------|----------|------------|----------|------------|
| **Assets**                                      |   |     | ** ** |     | ** ** |
| Cash and cash equivalents                       |   | $        | 45,516     |     | $          | 5,989 |   |
| Other investments                               |   | 63       |       | 63       |       |
| Investment in subsidiaries                      |   | 35,318   |       | 32,472   |       |
| Premises and equipment, net                     |   | 1,552    |       | 1,825    |       |
| Goodwill                                        |   | 22       |       | 646      |       |
| Other assets                                    |   | 3,489    |       | 164      |       |
|                                            |   |     |       |     |       |
| Total assets                                    |   | $        | 85,960     |     | $          | 41,159 |   |
|                                            |   |     |       |     |       |
| **Liabilities and Shareholders’ Equity**   |   |     |       |     |       |
|                                            |   |     |       |     |       |
| Total liabilities                               |   | $        | 548        |     | $          | 447 |   |
|                                            |   |     |       |     |       |
| Total shareholders’ equity                 |   | $        | 85,412     |     | $          | 40,712 |   |
|                                            |   |     |       |     |       |
| Total liabilities and shareholders’ equity |   | $        | 85,960     |     | $          | 41,159 |   |

 

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PARENT COMPANY ONLY CONDENSED STATEMENTS OF OPERATIONS

 

Years Ended December 31, 2003, 2002 and 2001

 

(Dollars in thousands)

 
|                                                                               |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Income:                                                                            |   |     |   |     |   |     |   |
| Interest income                                                                    |   | $        | 96     |     | $      | 81       |   | $ | 26 |   |
| Other income                                                                       |   | 32       |   | 74       |   | 43       |   |
|                                                                               |   |     |   |     |   |     |   |
| Total income                                                                       |   | 128      |   | 155      |   | 69       |   |
|                                                                               |   |     |   |     |   |     |   |
| Expense - General and administrative                                               |   | 1,270    |   | 463      |   | 2,545    |   |
|                                                                               |   |     |   |     |   |     |   |
| Net loss before income taxes and equity in  undistributed earnings of subsidiaries |   | (1,142   | )      | (308     | )      | (2,476   | )      |
|                                                                               |   |     |   |     |   |     |   |
| Income tax benefit                                                                 |   | (2,601   | )      | —   |   | —   |   |
|                                                                               |   |     |   |     |   |     |   |
| Equity in undistributed earnings of subsidiaries                                   |   | 4,695    |   | (221     | )      | (10,248  | )      |
|                                                                               |   |     |   |     |   |     |   |
| Net income (loss)                                                                  |   | $        | 6,154  |     | $      | (529     | )      | $ | (12,724 | ) |

 

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PARENT COMPANY ONLY CONDENSED STATEMENTS OF CASH FLOWS

 

Years ended December 31, 2003, 2002 and 2001

 

(Dollars in thousands)

 
|                                                                                                |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash flows from operating activities:                                                               |   |     |   |     |   |     |   |
| Net income (loss)                                                                                   |   | $        | 6,154  |     | $      | (529     | )      | $ | (12,724 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |   |     |   |     |   |     |   |
| Equity in undistributed earnings of subsidiaries                                                    |   | (4,695   | )      | 221      |   | 10,248   |   |
| Depreciation and amortization of goodwill                                                           |   | 261      |   | 238      |   | 865      |   |
| (Increase) decrease in other assets, liabilities  and goodwill                                      |   | (2,600   | )      | (2,413   | )      | 1,754    |   |
|                                                                                                |   |     |   |     |   |     |   |
| Net cash provided by (used in) operating  activities                                                |   | (880     | )      | (2,483   | )      | 143      |   |
|                                                                                                |   |     |   |     |   |     |   |
| Cash flows from investing activities:                                                               |   |     |   |     |   |     |   |
| Capital infusions in subsidiaries                                                                   |   | (1,000   | )      | (12,275  | )      | (720     | )      |
| Net change in premises and equipment                                                                |   | 11       |   | 161      |   | 158      |   |
| Proceeds from sale of other investments                                                             |   | —   |   | 4        |   | 17       |   |
|                                                                                                |   |     |   |     |   |     |   |
| Net cash used in investing activities                                                               |   | (989     | )      | (12,110  | )      | (545     | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Cash flows from financing activities:                                                               |   |     |   |     |   |     |   |
| Proceeds from rights and secondary offerings                                                        |   | 41,747   |   | 18,493   |   | —   |   |
| Dividends declared on preferred stock                                                               |   | (495     | )      | (495     | )      | (503     | )      |
| Stock options exercised                                                                             |   | 144      |   | —   |   | 11       |   |
|                                                                                                |   |     |   |     |   |     |   |
| Net cash provided by (used in) financing  activities                                                |   | 41,396   |   | 17,998   |   | (492     | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Net increase (decrease) in cash and cash  equivalents                                               |   | 39,527   |   | 3,405    |   | (894     | )      |
|                                                                                                |   |     |   |     |   |     |   |
| Cash and cash equivalents at beginning of year                                                      |   | 5,989    |   | 2,584    |   | 3,478    |   |
|                                                                                                |   |     |   |     |   |     |   |
| Cash and cash equivalents at end of year                                                            |   | $        | 45,516 |     | $      | 5,989    |   | $ | 2,584 |   |

 

(19)                            Goodwilland Other Intangible Assets

 

**In 2001, the Company substantially eliminated the goodwillattributable from the acquisition of Heritage Bancorp, Inc.  The initial investment in Heritage, whichwas subsequently, renamed Cardinal Bank – Potomac, resulted in the Companyrecording $9.7 million of goodwill at the time of the acquisition.  In the fourth quarter of 2001, an evaluationof 2001 losses and expectations of additional future losses indicated apotential impairment in the Company’s investment in Heritage.  In compliance with SFAS No. 121, the Companywrote down goodwill by $8.3 million based upon a valuation obtained from anindependent third party consultant.  In2003, the Company recognized the benefit of net operating loss carryforwardsarising from the Heritage acquisition, and accordingly, this tax benefit of$624,000 was utilized to reduce the**

 

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**Heritage goodwill. Goodwill at December 31, 2003 and 2002 was $22,000 and $646,000,respectively.**

 

**The Company adopted SFAS No. 142 as of January 1, 2002,and, therefore, discontinued the amortization of goodwill on January 1,2002.  The Company has evaluatedimpairment of goodwill under SFAS No. 142. The evaluation of goodwill underthis statement did not result in impairment of the Company’s goodwill as of theannual evaluation date.  Information onthe Company’s intangible assets is contained in the table below.**

 
|                                |   | **December  31, 2003**    |   | **December  31, 2002**        |   |
|-------------------------------------|--------|---------------------------|--------|-------------------------------|--------|
| **(Dollars in thousands)**          |   | **Gross  Carrying Value** |   | **Accumulated  Amortization** |   | **Gross  Carrying Value** |   | **Accumulated  Amortization** |   |
| Amortizable core deposit intangible |   | $                         | 102    |                          | $      | (102 | ) | $ | 102 |   | $ | (102 | ) |
| Unamortizable goodwill              |   | 22                        |   | —                        |   | 646 |   | — |   |
|                                     |        |                           |        |                               |        |  |  |  |  |  |  |  |  |

 
|                                  |   | **Core  Deposit  Intangible** |   |
|---------------------------------------|--------|-------------------------------|--------|
| **Amortization expense:**             |   |                          |   |
| Twelve months ended December 31, 2003 |   | —                        |   |
| Twelve months ended December 31, 2002 |   | 22                            |   |

 

 
|                                              |   | **December  31,** |   |
|---------------------------------------------------|--------|-------------------|--------|
|                                              |   | **2003**          |   | **2002** |   | **2001** |   |
| Reported net income (loss) to common shareholders |   | $                 | 5,659  |   | $ | (1,024 | ) | $ | (13,227 | ) |
| Add: goodwill amortization                        |   | —            |   | — |   | 8,847 |   |
| Adjusted net income (loss)                        |   | 5,659             |   | (1,024 | ) | (4,380 | ) |
|                                              |   |              |   |   |   |   |   |
| Reported basic earnings (loss) per common share   |   | $                 | 0.55   |   | $ | (0.13 | ) | $ | (3.11 | ) |
| Add: goodwill amortization per common share       |   | —            |   | — |   | 2.08 |   |
| Adjusted basic earnings (loss) per common share   |   | $                 | 0.55   |   | $ | (0.13 | ) | $ | (1.03 | ) |
|                                              |   |              |   |   |   |   |   |
| Reported diluted earnings (loss) per common share |   | $                 | 0.54   |   | $ | (0.13 | ) | $ | (3.11 | ) |
| Add: goodwill amortization per common share       |   | —            |   | — |   | 2.08 |   |
| Adjusted diluted earnings (loss) per common share |   | $                 | 0.54   |   | $ | (0.13 | ) | $ | (1.03 | ) |

 

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At December 31, 2002, the Company’s core deposit intangible was fullyamortized thus; there is no more amortization expense after December 31, 2002.

 

(21)                            OtherOperating Expenses

 

**The following shows the composition of operating expensesfor the years ended December 31, 2003, 2002 and 2001:**

 
| **(Dollars in thousands)**     |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Data processing                |   | $        | 835    |     | $      | 759      |   | $ | 957 |   |
| Stationery and supplies        |   | 387      |   | 317      |   | 306      |   |
| Brokerage clearing             |   | 186      |   | 206      |   | 370      |   |
| Advertising and marketing      |   | 913      |   | 541      |   | 368      |   |
| Telecommunications             |   | 396      |   | 276      |   | 325      |   |
| Other taxes                    |   | 456      |   | 342      |   | 269      |   |
| Travel and entertainment       |   | 148      |   | 127      |   | 164      |   |
| Bank operations                |   | 569      |   | 411      |   | 875      |   |
| Premises and equipment         |   | 351      |   | 271      |   | 247      |   |
| Miscellaneous                  |   | 686      |   | 239      |   | 465      |   |
| Total other operating expenses |   | $        | 4,927  |     | $      | 3,489    |   | $ | 4,346 |   |

 

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**Item 8**.  Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure

** **

**No changes in the Company’s independent accountants ordisagreements on accounting and financial disclosure required to be reportedhereunder have taken place.**

** **

**Item 8A**. Controls and Procedures

** **

**The Company maintains disclosure controls and proceduresthat are designed to ensure that information required to be disclosed by it inthe reports that it files or submits under the Securities Exchange Act of 1934,as amended, is recorded, processed, summarized and reported within the timeperiods required by the Securities and Exchange Commission, including, withoutlimitation, those controls and procedures designed to ensure that suchinformation is accumulated and communicated to the Company’s management toallow timely decisions regarding required disclosures.**

** **

**As of the end of the period covered by this report, anevaluation of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures was carried out under the supervision andwith the participation of the Company’s management, including the chiefexecutive officer and chief financial officer. Based on and as of the date of such evaluation, these officers concludedthat the Company’s disclosure controls and procedures were effective.**

** **

**The Company also maintains a system of internal accountingcontrols that is designed to provide assurance that assets are safeguarded andthat transactions are executed in accordance with management’s authorizationand properly recorded.  This system iscontinually reviewed and is augmented by written policies and procedures, thecareful selection and training of qualified personnel and an internal auditprogram to monitor its effectiveness. There were no changes in our internal control over financial reportingidentified in connection with our evaluation of it that occurred during ourlast fiscal quarter that materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.**

 

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**PART III****.**

 

**Item9.  Directors, Executive Officers,Promoters and Control Persons; Compliance with Section 16(a) of the ExchangeAct**

 

Pursuant toGeneral Instruction E(3) of Form 10-KSB, the information contained in the“Election of Directors” section, under the headings “Executive Officers” and“Section 16(a) Beneficial Ownership Reporting Compliance” and in the “TheCommittees of the Board of Directors – Audit Committee” subsection with respectto the designation of James D. Russo as an audit committee financial expert inthe Company’s Proxy Statement for the 2004 Annual Meeting of Shareholders isincorporated herein by reference.

 

We do not havea code of ethics for our senior financial management.  We are currently drafting such a code in connection with othercorporate governance compliance matters and expect to have it effective by May2004.  The addendum will address, amongother things, standards that are reasonably necessary to promote honest andethical conduct, including conduct with respect to conflicts of interest, full,fair, accurate, timely and understandable disclosure in our required periodicreports and compliance with applicable governmental rules and regulations.  Upon adoption, we will make it publiclyavailable.

 

**Item10.  Executive Compensation**

 

Pursuant toGeneral Instruction E(3) of Form 10-KSB, the information contained under theheadings “Director Compensation,” “Executive Officer Compensation,” “StockOptions” and “Employment Agreements” in the Company’s Proxy Statement for the2004 Annual Meeting of Shareholders is incorporated herein by reference.

 

**Item11.  Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

 

Pursuant toGeneral Instruction E(3) of Form 10-KSB, the information contained under the headings“Security Ownership of Directors and Executive Officers” and “SecurityOwnership of Certain Beneficial Owners” and in the “Stock Options” subsectionwith respect to “Securities Authorized for Issuance Under Equity CompensationPlans” in the Company’s Proxy Statement for the 2004 Annual Meeting ofShareholders is incorporated herein by reference.

 

**Item12.  Certain Relationships and RelatedTransactions**

 

Pursuant to General InstructionE(3) of Form 10-KSB, the information contained under the heading “CertainRelationships and Related Transactions” in the Company’s Proxy Statement forthe 2004 Annual Meeting of Shareholders is incorporated herein by reference.

** **

**85**

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** **

**Item 13**.  Exhibits and Reports on Form 8-K

** **

(a)                                  Exhibits.

 

3.1                                 Articles of Incorporation of CardinalFinancial Corporation (incorporated by reference to Exhibit 3.1 to theRegistration Statement on Form SB-2, Registration No. 333-82946 (the “FormSB-2”)).

 

3.2                                 Articles of Amendmentto the Articles of Incorporation of Cardinal Financial Corporation, settingforth the designation for the Series A Preferred Stock (incorporated byreference to Exhibit 3.2 to the Form SB-2).

 

3.3                                 Bylaws of CardinalFinancial Corporation (restated in electronic format to reflect all amendmentsthrough September 9, 2003), (incorporated by reference to Exhibit 3.3to the Registrant’s Registration Statement on Form SB-2, as amended,Registration No. 333-110693).

 

4.1                                 Form of Common StockCertificate (incorporated by reference to Exhibit 4.1 to the Form SB-2).

 

10.1                           Employment Agreement, datedas of February 12, 2002, between Cardinal Financial Corporation and Bernard H.Clineburg (incorporated by reference to Exhibit 10.1 to the Form SB-2).

 

10.2                           Executive Employment Agreement,dated as of February 12, 2002, between Cardinal Financial Corporation and CarlE. Dodson (incorporated by reference to Exhibit 10.2 to the Form SB-2).

 

10.3                           Executive EmploymentAgreement, dated as of February 12, 2002 between Cardinal Financial Corporationand F. Kevin Reynolds (incorporated by reference to Exhibit 10.4 to the FormSB-2).

 

10.4                           Executive EmploymentAgreement, dated as of February 12, 2002, between Cardinal FinancialCorporation and Christopher W. Bergstrom (incorporated by reference to Exhibit10.5 to the Form SB-2).

 

10.5                           Cardinal Financial Corporation 1999 StockOption Plan, as amended (incorporated by reference to Exhibit 10.7 to the FormSB-2).

 

86

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10.6                           Cardinal Financial Corporation2002 Equity Compensation Plan (incorporated by reference to Exhibit 10.8 to theQuarterly Report on Form 10-QSB for the period ended June 30, 2002).

 

21                                    Subsidiaries ofCardinal Financial Corporation.

 

23                                    Consent of KPMG LLP

 

31.1                           Rule13a-14(a) Certification of Chief Executive Officer

 

31.2                           Rule13a-14(a) Certification of Chief Financial Officer

 

32.1                           Statement of Chief ExecutiveOfficer Pursuant to 18 U.S.C. § 1350.

 

32.2                           Statement of Chief FinancialOfficer Pursuant to 18 U.S.C. § 1350.

 

(b) Reports on Form 8-K

 

On October 22, 2003, the Company furnished to the SEC a Current Reporton Form 8-K dated October 16, 2003 under Item 12, including its financialresults for the quarter ended September 30, 2003.

 

**Item 14**.  Principal Accountant Fees and Services

** **

**Pursuant to General Instruction E(3) of Form 10-KSB, theinformation contained under the headings “Fees of Independent PublicAccountants” and “Audit Committee Pre-Approval Policies and Procedures” in theCompany’s Proxy Statement for the 2004 Annual Meeting of Shareholders isincorporated herein by reference.**

 

87

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**SIGNATURES**

** **

**Inaccordance with Section 13 and 15 (d) of the Securities Exchange Act of 1934,as amended, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized, in the County of Fairfax, Commonwealthof Virginia, on March 29, 2004.**

** **
|   | **CARDINAL  FINANCIAL CORPORATION** |
|--------|-------------------------------------|
|   |                                |
|   | **By:**                             | **/s/ Bernard H. Clineburg** |   |
|   | **Name:  Bernard H. Clineburg**     |
|   | **Title:**                          | **Chairman,  President and Chief Executive Officer** |
|   |                                | **(Principal  Executive Officer)** |
|        |                                     |  |  |  |

 

**Inaccordance with the Securities Exchange Act of 1934, as amended, this reporthas been filed below by the following persons in the capacities indicated onMarch 29, 2004.**

** **
| **Signatures**                  |   | **Titles** |
|---------------------------------|--------|------------|
|                            |   |       |
| **/s/  Bernard H. Clineburg**   |   |       | **Chairman,  President and Chief Executive Officer** |
| **Name:  Bernard H. Clineburg** |   |       | **(Principal  Executive Officer)** |
|                            |   |       |   |
| **/s/  Domingo Rodriguez**      |   |       | **Senior  Vice President and Chief Financial Officer** |
| **Name:  Domingo Rodriguez**    |   |       | **(Principal  Financial Officer)** |
|                            |   |       |   |
| **/s/  Jennifer L. Deacon**     |   |       | **Vice  President and Controller** |
| **Name:  Jennifer L. Deacon**   |   |       | **(Principal  Accounting Officer)** |
|                            |   |       |   |
| **/s/ B.  G. Beck**             |   |       | **Director** |
| **Name:  B. G. Beck**           |   |       |   |
|                            |   |       |   |
| **/s/  Wayne W. Broadwater**    |   |       | **Director** |
| **Name:  Wayne W. Broadwater**  |   |       |   |
|                            |   |       |   |
| **/s/  William G. Buck**        |   |       | **Director** |
| **Name:  William G. Buck**      |   |       |   |
|                            |   |       |   |
| **/s/  Sidney O. Dewberry**     |   |       | **Director** |
| **Name:  Sidney O. Dewberry**   |   |       |   |
|                            |   |       |   |
| **/s/  John W. Fisher**         |   |       | **Director** |
| **Name:  John W. Fisher**       |   |       |   |
|                            |   |       |   |
| **/s/  Michael A. Garcia**      |   |       | **Director** |
| **Name:  Michael A. Garcia**    |   |       |   |
|                            |   |       |   |
| **/s/ J.  Hamilton Lambert**    |   |       | **Director** |
| **Name:  J. Hamilton Lambert**  |   |       |   |
|                            |   |       |   |
| **/s/  William E. Peterson**    |   |       | **Director** |
| **Name:  William E. Peterson**  |   |       |   |

 

88

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| **/s/  James D. Russo**      |   |   | **Director** |
|------------------------------|--------|--------|--------------|
| **Name:  James D. Russo**    |   |   |         |
|                         |   |   |         |
| **/s/  John H. Rust, Jr.**   |   |   | **Director** |
| **Name:  John H. Rust, Jr.** |   |   |         |
|                         |   |   |         |
| **/s/  Emad Saadeh**         |   |   | **Director** |
| **Name:  Emad Saadeh**       |   |   |         |
|                         |   |   |         |
| **/s/  George P. Shafran**   |   |   | **Director** |
| **Name:  George P. Shafran** |   |   |         |
|                         |   |   |         |
| **/s/  Alice M. Starr**      |   |   | **Director** |
| **Name:  Alice M. Starr**    |   |   |         |

 

89

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**EXHIBIT INDEX**

 
| **Number** |   | **Description**                                                                                                                                                                                                                                                                                    |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                               |
| 3.1        |   | Articles of Incorporation of Cardinal Financial  Corporation (incorporated by reference to Exhibit 3.1 to the Registration  Statement on Form SB-2, Registration No. 333-82946 (the “Form SB-2”)).                                                                                       |
|       |   |                                                                                                                                                                                                                                                                                               |
| 3.2        |   | Articles of Amendment to the Articles of Incorporation of Cardinal  Financial Corporation, setting forth the designation for the Series A  Preferred Stock (incorporated by reference to Exhibit 3.2 to the Form SB-2).                                                                            |
|       |   |                                                                                                                                                                                                                                                                                               |
| 3.3        |   | Bylaws of Cardinal Financial Corporation (restated in electronic  format to reflect all amendments through September 9, 2003),  (incorporated by reference to Exhibit 3.3 to the Registrant’s  Registration Statement on Form SB-2, as amended, Registration  No. 333-110693). |
|       |   |                                                                                                                                                                                                                                                                                               |
| 4.1        |   | Form of Common Stock Certificate (incorporated by reference to  Exhibit 4.1 to the Form SB-2).                                                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                               |
| 10.1       |   | Employment Agreement, dated as of February 12, 2002, between Cardinal  Financial Corporation and Bernard H. Clineburg (incorporated by reference to  Exhibit 10.1 to the Form SB-2).                                                                                                               |
|       |   |                                                                                                                                                                                                                                                                                               |
| 10.2       |   | Executive Employment Agreement, dated as of February 12, 2002,  between Cardinal Financial Corporation and Carl E. Dodson (incorporated by  reference to Exhibit 10.2 to the Form SB-2).                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                               |
| 10.3       |   | Executive Employment Agreement, dated as of February 12, 2002 between  Cardinal Financial Corporation and F. Kevin Reynolds (incorporated by  reference to Exhibit 10.4 to the Form SB-2).                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                               |
| 10.4       |   | Executive Employment Agreement, dated as of February 12, 2002,  between Cardinal Financial Corporation and Christopher W. Bergstrom  (incorporated by reference to Exhibit 10.5 to the Form SB-2).                                                                                                 |
|       |   |                                                                                                                                                                                                                                                                                               |
| 10.5       |   | Cardinal Financial Corporation 1999 Stock Option  Plan, as amended (incorporated by reference to Exhibit 10.7 to the Form  SB-2).                                                                                                                                                                  |
|       |   |                                                                                                                                                                                                                                                                                               |
| 10.6       |   | Cardinal Financial Corporation 2002 Equity Compensation Plan  (incorporated by reference to Exhibit 10.8 to the Quarterly Report on Form  10-QSB for the period ended June 30, 2002).                                                                                                              |
|       |   |                                                                                                                                                                                                                                                                                               |
| 21         |   | Subsidiaries of Cardinal Financial Corporation.                                                                                                                                                                                                                                                    |
|       |   |                                                                                                                                                                                                                                                                                               |
| 23         |   | Consent of KPMG LLP                                                                                                                                                                                                                                                                                |
|       |   |                                                                                                                                                                                                                                                                                               |
| 31.1       |   | Rule 13a-14(a) Certification of Chief Executive Officer                                                                                                                                                                                                                                            |
|       |   |                                                                                                                                                                                                                                                                                               |
| 31.2       |   | Rule 13a-14(a) Certification of Chief Financial Officer                                                                                                                                                                                                                                            |
|       |   |                                                                                                                                                                                                                                                                                               |
| 32.1       |   | Statement of Chief Executive Officer Pursuant to 18 U.S.C. § 1350.                                                                                                                                                                                                                            |
|       |   |                                                                                                                                                                                                                                                                                               |
| 32.2       |   | Statement of Chief Financial Officer Pursuant to 18 U.S.C. § 1350.                                                                                                                                                                                                                            |

 

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