**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-KSB**

 

**ANNUAL REPORT UNDER SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31, 2002**

 

**Commission file number 0-24557**

 

**CARDINAL FINANCIAL CORPORATION**

(Name of Small BusinessIssuer 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’sTelephone Number, Including Area Code)

 

Securitiesregistered under Section 12(g) of the Exchange Act:

 

**Common Stock, par value $1.00 pershare**

**7.25% Cumulative ConvertiblePreferred Stock, Series A, par value $1.00 per share**

(Title of Class)

 

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

 

Check if there is no disclosure of delinquent filersin response to Item 405 of Regulation S-B contained in this form, and nodisclosure will be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-KSB or any amendment to this Form10-KSB.           o

 

The issuer’s revenues for the fiscal year ended December31, 2002 were $23,515,000.

 

The aggregate market value of the voting shares heldby non-affiliates computed by reference to the price at which the stock wassold, or the average bid and asked prices of such stock, as of March 11, 2003was $42,544,789.

 

The number of shares outstanding of Common Stock, asof March 11, 2003 was 10,047,345.

 

 

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**TABLE OF CONTENTS**

 
| **PART I**   |
|--------------|
|         |   |   |
| Item 1.      |   | Description of Business |   |   | 3 |
|         |   |   |   |   |   |   |   |
| Item 2.      |   | Description of Property |   |   | 19 |
|         |   |   |   |   |   |   |   |
| Item  3.     |   | Legal  Proceedings |   |   | 20 |
|         |   |   |   |   |   |   |   |
| Item  4.     |   | Submission  of Matters to a Vote of Security Holders | 20 |
|         |   |   |   |   |   |   |   |
| **PART II**  |
|         |   |   |   |   |   |   |   |
| Item  5.     |   | Market  for Common Equity and Related Stockholder Matters | 20 |
|         |   |   |   |   |   |   |   |
| Item  6.     |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 21 |
|         |   |   |   |   |   |   |   |
|         |   |   |   |   |   |   |   |
|         |   |   |   |   |   |   |   |
| Item 7.      |   | Financial Statements |   |   | 44 |
|         |   |   |   |   |   |   |   |
| Item  8.     |   | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure | 77 |
|         |   |   |   |   |   |   |   |
| **PART III** |
|         |   |   |   |
| Item  9.     |   | Directors,  Executive Officers, Promoters and Control Persons; Compliance with Section  16(a) of the Exchange Act | 77 |
|         |   |   |   |   |   |   |   |
|         |   |   |   |   |   |   |   |
| Item 10.     |   | Executive Compensation |   |   | 77 |
|         |   |   |   |   |   |   |   |
| Item  11.    |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters | 77 |
|         |   |   |   |   |   |   |   |
| Item  12.    |   | Certain  Relationships and Related Transactions | 78 |
|         |   |   |   |   |   |   |   |
| Item 13.     |   | Exhibits,  List and Reports on Form 8-K | 78 |
|              |  |  |  |  |  |  |  |  |  |  |

 

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**PARTI**

 

**Item1.****           Descriptionof Business**

 

Overview

 

We own Cardinal Bank, N.A., a nationally charteredfull-service community bank. Cardinal Bank has offices in Alexandria,Arlington, Fairfax City, Reston, Sterling, Manassas, Tysons Corner andMcLean.  We have an investment advisorysubsidiary, Cardinal Wealth Services, Inc., which began operations on February1, 1999. We conduct virtually all of our business through Cardinal Bank, N.A.and Cardinal Wealth Services, Inc.

 

In March 2003, werelocated our principal executive offices to 8270 Greensboro Drive, McLean,Virginia, 22102.  Our Internet websiteaddress is www.cardinalbank.com.

 

History

 

Cardinal FinancialCorporation was formed in late 1997, principally in response to opportunitiesresulting from the takeovers of several Virginia-based banks by regional bankholding companies and bank consolidations. In our market area, these bank takeovers and consolidations had beenaccompanied by the dissolution of local boards of directors and relocation ortermination of management and customer service professionals.

 

Our initial strategy wasto operate a multi-bank organization that emphasized decision-making at thelocal bank level combined with strong, centralized corporate, technological,marketing, financial and managerial support. Our operating model was for each local community bank to operate withlocal management and boards of directors consisting of individuals withextensive knowledge of the local community and the authority to make creditdecisions.  We believed that thisoperating strategy would give us a competitive advantage by coupling thebenefits of local banking to attract customers who wished to conduct theirbusiness with a locally owned and managed institution with strong ties and anactive commitment to the community with the economies of centralizedaccounting, operations and administrative oversight.

 

We implemented ourinitial strategy by organizing Cardinal Bank N.A., headquartered in Fairfax,Virginia, as a wholly owned subsidiary that commenced operations on June 8,1998.  Subsequently, we organized twoadditional wholly owned subsidiaries: Cardinal Bank – Manassas/Prince William,N.A., headquartered in Manassas, Virginia, that commenced operations on July26, 1999; and Cardinal Bank – Dulles, N.A., headquartered in Reston, Virginia,that commenced 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.

 

The results of ourinitial strategy were successful from the standpoint of growth in core depositsand loans.  By September 30, 2001, loanshad grown to $197 million, deposits had reached $213 million, total assetsexceeded $250 million, and we had become the fourth largest community bankheadquartered in our target market, measured by total deposits.  All three larger competitors had been inbusiness for over ten years.

 

Despite significantgrowth, we continued to experience operating losses.  The level of non-interest expense created by operating fourseparate banks, including personnel expenses for four fully-staffed banks, plusoccupancy expense for four headquarters facilities, continued to exceed revenuegenerated by net interest and fee income. In addition, the operation of four separate banks negatively affectedoperating efficiencies with respect to centralized accounting, depositoperations, credit administration, and information technology.

 

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Shift in OperatingStrategy

 

In the summer of 2001, weconcluded that the inherent operational inefficiencies of conducting bankingactivities through four separate subsidiary banks resulted in costs that placedus at a significant competitive disadvantage and impeded our ability to achieveprofitability.  In recognition of this andin the interest of achieving profitability as quickly as possible, we began theprocess of reorganizing and restructuring our operations for greater growth andprofitability.

 

In October 2001, theboard of directors named Bernard H. Clineburg as our Chairman, President andChief Executive Officer.  After  Mr. Clineburg’s arrival, we took stepsdesigned to streamline our operations, reduce costs and achieveprofitability.  In particular:

 

•                  We completed theconsolidation of our original four banking subsidiaries into a single bank inorder to reduce costs and streamline operations and decision-making.  The merger of Cardinal Bank — Dulles, N.A.and Cardinal Bank — Potomac into Cardinal Bank, N.A. was completed in November2001.  The merger of CardinalBank-Manassas/Prince William, N.A. into Cardinal Bank, N.A., was completed asof March 1, 2002.

 

•                  We were requiredto evaluate our goodwill for impairment and in the fourth quarter of 2001, wehad an $8.3 million impairment of goodwill, substantially eliminating thegoodwill attributable to the purchase of Heritage Bancorp, Inc. in September2000.  An evaluation of losses incurredby Cardinal Bank — Potomac (the successor to The Heritage Bank) during 2000 and2001, coupled with expectations of future additional losses, indicated apotential impairment in our investment in Heritage.  A valuation of Cardinal Bank — Potomac was performed by anexternal consultant in response to these impairment indicators.  The valuation confirmed a significantimpairment in the Company’s investment in Heritage and resulted in the writedown of goodwill.

 

•                  We furtherreduced staffing levels during the fourth quarter of 2001. We reduced ournumber of employees from 138 on June 30, 2001 to 105 as of December 31,2001.  Most of the staff reductions weremade in the commercial lending area of the bank, which had become overstaffedin light of the shift in strategy from four banks to one.  Significant reductions in staff were alsomade in our centralized administration areas, including accounting, depositoperations and credit administration.

 

•                  We subleasedexcess commercial space at our Alexandria, Manassas, McLean and Restonfacilities.

 

These steps significantlyreduced overhead expenses  and helped usachieve profitability during the third and fourth quarters of 2002.  Despite the significant management andoperational changes experienced  2001and 2002, we continued to experience annualized asset growth in excess of 74.0%during 2002, with total assets reaching $486.3 million as of December 31,2002.  We remain committed tocontinually increase our share of  thelocal bank deposit market while improving profitability levels.

 

During the second quarterof 2002, we completed successful rights and secondary offerings that resultedin $18.5 million in additional capital for the Company. We offered 2,500,000shares to existing shareholders of record as of February 1, 2002 and 2,500,000shares to the public. The proceeds from the offerings were used to support ourcontinued growth and have contributed to our improved profitability.Specifically, we have used and plan to use the proceeds from the rights andsecondary offerings for the following:

 

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•                  We plan toexpand our branch network  and increasecore retail deposits by developing and marketing innovative consumer orientedproducts and services.  We began theimplementation of this plan through our Arlington branch opening in November2002. In January 2003 we announced an agreement to purchase or lease up to fiveexisting branch offices in Northern Virginia and to open up to three of thebranches by the middle of 2004.  Furtherconsolidation of branch locations is expected in our target market as severalmergers of large regional and national banks are completed over the coming months.  This consolidation is expected to createadditional opportunities to significantly expand our branch network toattractive retail sites and increase our market share of bank deposits withinour target market.

 

•                  The capital weraised in the offerings has allowed us to have larger lending limits and hasallowed us to further expand our commercial lending activities, using thebreadth of experience of our senior lenders.

 

•                  Although we havenot at this time identified specific bank acquisition targets, we will explorethe possibility of further growth through acquisition in line with our currentoperating strategy.

 

•      We have expanded certain existing productlines, including government contract receivables lending, SBA guaranteedlending, and retail lending.  Our goalis to create a diversified, community-focused banking franchise, balancedbetween retail, commercial and real estate transactions and services.

 

•      Wehave formed our mortgage banking subsidiary but are delaying operations untilwe can identify and retain experienced management for the subsidiary.  In the meantime, we have partnered withInterfirstlink.com, a division of ABN AMRO Mortgage Group, which allows us tooriginate competitive residential mortgages for our customers.  All mortgages originated throughInterfirstlink.com are pre-approved and purchased by ABN AMRO.

 

Customers

 

We believe that the recent and ongoing bankconsolidation within Northern Virginia provides a significant opportunity tobuild a successful, locally-oriented franchise.  We also believe that many of the larger financial institutions donot emphasize a high level of personalized service to the small andmedium-sized commercial, professional or individual retail customers.  Our commercial relationship managers focus theirmarketing efforts on attracting small and medium-sized businesses andprofessionals, such as physicians, accountants and attorneys.  Because we focus on businesses andprofessionals, the majority of our loan portfolio is in the commercial areawith an emphasis placed on originating sound, profitable commercial andindustrial loans secured by real estate, accounts receivable, inventory,property, plant and equipment.

 

Although we expect to continue serving the businessand professional market with experienced commercial relationship managers, wehave increased our marketing efforts to retail consumers through the expansionof our branch network and development of innovative 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.

 

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 advanced automated accounting system, which supports

 

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virtually every banking function. The system provides the technology that fully automates the branches,processes bank transactions, mortgages, loans and electronic banking, conductsdata base and direct response marketing, provides cash management solutions,streamlined reporting and reconciliation support as well as sales support.

 

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

 

We currently have eight full service banking offices,which are staffed by 38 full-time employees and 10 part-time employees.  We offer a broad array of banking productsand services to our customers.  Theseproducts and services are set forth below.

 

*Loans*

 

We offer a wide range ofshort- to long-term commercial and consumer loans, which are described infurther detail below.  We haveestablished pre-determined percentage levels as targets for the division of ourloan portfolio across the various categories of loans.  Commercial loans, real estate-commercialloans, real estate-construction loans, real estate-residential loans, homeequity loans, and consumer loans account for approximately 23.4%, 46.6%, 2.3%,12.8%, 10.8% and 4.1%, respectively of our loan portfolio at December 31, 2002.  We believe that this division reflects thecurrent credit demands of our market and provides a sufficient amount ofdiversification to avoid over-reliance on one category.  We may adjust these levels from time to timeas the credit demands of the community change and as our business evolves.

 

*CreditPolicies*

 

Our senior lendingofficers and chief credit officer are primarily responsible for maintaining aquality loan portfolio and developing a strong credit culture throughout theentire organization.  The chief creditofficer is responsible for developing and updating our credit policies andprocedures.  Senior lendingofficers  may make exceptions to thesecredit policies and procedures as appropriate, but any such exception must beapproved by the chief credit officer, documented and made for sound businessreasons.

 

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 the bank’s board ofdirectors.  In addition, the chiefcredit officer works closely with each lending officer at the bank level toensure that the business being solicited is of the quality and structure thatfits our desired risk profile.

 

Under our credit policies, we generally limit ourconcentration of credit risk in any loan or group of loans to 30% of the bank’scapital.  Such concentration limitpertains to any group of borrowers related as to the source of repayment or anyone specific 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.

 

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*CommercialLoans*

 

We make commercial loansto qualified 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.  We also offerSmall Business Administration guaranteed loans and asset-based lendingarrangements to certain of our customers.

 

Commercial loansgenerally have a higher degree of risk than residential mortgage loans, buthave commensurately higher yields. Residential mortgage loans generally are made on the basis of theborrower’s ability to make repayment 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 makerepayment from cash flow from its business and are secured by business assets,such as commercial real estate, accounts receivable, equipment andinventory.  As a result, theavailability of funds for the repayment of commercial loans may besubstantially dependent on the success of the business itself.  Further, the collateral for commercial loansmay depreciate over time and cannot be appraised with as much precision asresidential real estate.

 

To manage these risks, our policy is to securecommercial loans with both the assets of the borrowing business and otheradditional collateral and guarantees that may be available.  In addition, we actively monitor certainmeasures of the borrower, including advance rate, cash flow, collateral valueand other appropriate credit factors.

 

*CommercialMortgage Loans*

 

We also originatecommercial mortgage loans.  These loansare primarily secured by various types of commercial real estate, includingoffice, retail, warehouse, industrial and other non-residential types ofproperties and are made to the owners and/or occupiers of such property.  These loans have maturities generallyranging 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 paymentexperience on loans secured by income producing properties is typicallydependent on the successful operation of a business or a real estate projectand thus may be subject, to a greater extent than is the case with residentialmortgage loans, to adverse conditions in the real estate market or in theeconomy generally.  Our commercial realestate loan underwriting criteria require an examination of debt servicecoverage ratios, the borrower’s creditworthiness and prior credit history andreputation, and we generally require personal guarantees or endorsements.  We also carefully consider the location ofthe property that will be collateral for the loan.

 

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

 

*ResidentialMortgage Loans*

 

Our residential mortgageloans consist 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

 

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of maturities.  Maturities forconstruction loans generally range from six to twelve months for residentialproperty and from twelve to eighteen months for non-residential andmulti-family properties.

 

Residential mortgageloans generally are made on the basis of the borrower’s ability to makerepayment from his or her employment and other income and are secured by realestate the value of which tends to be easily ascertainable.  These loans are made consistent with ourappraisal and real estate lending policies, which detail maximum loan-to-valueratios and maturities.  Residential mortgageloans and home equity lines of credit secured by owner-occupied propertygenerally are made with a loan-to-value ratio of up to 80%.   Loan-to-value ratios of up to 90% may beallowed on residential owner-occupied property based on the borrower’s unusuallystrong general liquidity, net worth and cash flow.

 

*Construction Loans*

 

Construction lendingentails significant additional risks compared with residential mortgagelending.  Construction loans ofteninvolve larger loan balances concentrated with single borrowers or groups ofrelated borrowers.  Construction loansalso involve additional risks attributable to the fact that loan funds areadvanced upon the security of property under construction, which is of uncertainvalue prior to the completion of construction. Thus, it is more difficult to evaluate accurately the total loan fundsrequired to complete a project and related loan-to-value ratios.  To minimize the risks associated withconstruction lending, we limit loan-to-value ratios for owner occupiedresidential or commercial properties to 80%, and for investor-owned residentialor commercial properties to 75% of when-completed appraised values.  We expect that the loan-to-value ratiosdescribed above will be sufficient to compensate for fluctuations in the realestate market to minimize the risk of loss.

 

*Consumer Loans*

 

Our consumer loansconsist primarily of installment loans to individuals for personal, family andhousehold purposes.  The specific typesof consumer loans we make include home improvement loans, debt consolidationloans and general consumer lending.

 

Consumer loans may entailgreater risk than residential mortgage loans, particularly in the case ofconsumer loans that are unsecured, such as lines of credit, or secured byrapidly depreciable assets such as automobiles.  In such cases, any repossessed collateral for a defaultedconsumer loan may not provide an adequate source of repayment of theoutstanding loan balance as a result of the greater likelihood of damage, lossor depreciation.  The remainingdeficiency often does not warrant further substantial collection effortsagainst the borrower.  In addition,consumer loan collections are dependent on the borrower’s continuing financialstability, and thus are more likely to be adversely affected by job loss,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 loanborrower against an assignee of such loan, such as the bank, and a borrower maybe able to assert against such assignee claims and defenses that it has againstthe seller of the underlying collateral.

 

Our policy for consumerloans is to accept moderate risk while minimizing losses, primarily through acareful analysis of the borrower.  Inevaluating consumer loans, we require our lending officers to review the borrower’slevel and stability of income, past credit history 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.

 

We also issue creditcards to certain of our customers.  Indetermining to whom we will issue credit cards, we evaluate the borrower’slevel and stability of income, past credit history and other factors.

 

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Finally, we make additional loans that are not classified in one of theabove categories.  In making such loans,we attempt to ensure that the borrower meets our credit quality standards.

 

*Purchase and Collection ofCommercial Accounts Receivable*

 

We offer a product to ourcommercial customers involving the purchase, management and collection ofaccounts receivable.  This product isoffered to small businesses that do not have capital levels sufficient toqualify for traditional accounts receivable lines of credit or whose borrowingneeds exceed the amount that could be borrowed under a traditional line ofcredit facility.  Instead of earninginterest on outstanding balances, we earn a discount fee on the amount ofreceivables purchased.  Receivables are closelymonitored and payments are directed to a lockbox controlled by us.  To manage risk, we perform independentverifications of purchased receivables and maintain payment reserves of atleast 10% of the amount advanced. Customers are required to repurchase all receivables that become aged 90days or more.  This repurchaseobligation is personally guaranteed by the principal owner(s) of ourcustomers.  In addition, we maintainboth fraud and accounts receivable insurance coverage on the purchased receivables.

 

*Loan Participations*

 

From time to time wepurchase and sell loan participations to or from other banks within our marketarea.  In addition, in 1999 and 2001, wepurchased two consumer loan portfolios from a bank outside of our market area.  All loan participations purchased have beenunderwritten using the bank’s standard and customary underwriting criteria.

 

*Deposits*

 

We offer a broad range ofinterest-bearing and noninterest-bearing deposit accounts, including commercialand retail checking accounts, money market accounts, individual retirementaccounts, regular interest-bearing savings accounts and certificates of depositwith a range of maturity date options. The primary sources of deposits are small and medium-sized businessesand individuals within our target market. Senior management has the authority to set rates within specifiedparameters in order to remain competitive with other financialinstitutions.  We do not currentlyengage in the purchase of any brokered deposits.  All deposits are 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*

 

We offer courier servicesto our business customers.  Courierservices permit us to provide the convenience and personalized service that ourcustomers require by scheduling pick-ups of deposits.

 

*Telephone and Internet Banking*

 

We believe that there isa strong demand within our market for telephone banking and Internetbanking.  Both services allow bothcommercial and retail customers to access detailed account information andexecute a wide variety of the banking transactions referred to above.  We believe that these services areparticularly attractive for our customers, as it enables them to conduct theirbanking business and monitor their bank accounts from remote locations.  Telephone and Internet banking assists us inattracting and retaining customers and encourages our customers to maintainmore of their banking relationships with us.

 

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*Automatic Teller Machines*

 

We have an ATM at each ofour branch offices and we make other financial institutions’ ATMs available toour customers.

 

*Other Products and Services*

 

We offer specializedproducts and services to our customers, such as travelers checks and safedeposit services.  We periodicallyevaluate other services such as trust services, insurance and other permissibleactivities.  We intend to introducethese services as they become economically viable.  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.

 

Brokerage and InvestmentAdvisory Services

 

Through our subsidiary,Cardinal Wealth Services, Inc., we provide financial and estate planningservices.  Cardinal Wealth Services hada strategic alliance with LM Financial Partners, Inc., a wholly ownedsubsidiary of Legg Mason Inc. until February 2003 and now has an alliancewith Raymond James Financial Services, Inc. Through this alliance, Cardinal Wealth Services financial advisors canoffer its 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.  Cardinal Wealth Servicesis located at 10641 Lee Highway, Fairfax, Virginia 22030 and has 3 full-timeemployees, including 2 financial advisors.

 

Market Area

 

Our target market area includes areas in and aroundFairfax County, Virginia, including the independent cities of Fairfax,Alexandria and Manassas, Virginia, as well as the counties of Arlington, PrinceWilliam and Loudoun.  We haveestablished full-service banking offices in eight  locations in the target market.

 

Our target market is the Northern VirginiaMetropolitan Statistical Area (MSA) and is part of the fourth largestmetropolitan statistical area in the nation. The population of the MSA in 2001 was approximately 2.2 million and isexpected to grow to over 2.4 million by 2010. Over 45% of the population is 25 years and older and have earned aBachelor’s Degree or higher.  This MSAhas a low unemployment rate and the per capita personal income in 2000  was in excess of $40,000.

 

Fairfax County is thelargest county in Virginia, with a population of approximately 985,000 in 2001,and is expected to grow to just under 1.1 million by 2010.  With a median household income of over$80,000, the county is one of the most affluent in the country.  The county is known as a major center forU.S. and international corporate headquarters, technical and professionalservice firms, and trade and professional organizations.  A highly skilled and educated labor forcecombined with a well-integrated transportation network, including access tothree major airports, positions Fairfax County for continued business growth andexpansion.  Our headquarters is locatedapproximately 7  miles west ofWashington, D.C. and 115 miles north of Richmond, Virginia.

 

Our target market is one of the strongest bankingmarkets in the nation.  As of June 30,2001, total FDIC insured bank deposits in our target market area, excludingdeposits of E*TRADE Bank, Capital One Bank, and Treasury Bank (which, althoughbased in our target market area, draw deposits nationally), was $28 billion, up14 % from the prior year. Of the $28 billion in bank deposits in our target

 

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market area, just over 75% were held by banks based outside of ourtarget market area.  A major focus ofour revised strategy is to gain a larger share of this robust market for insuredbank deposits.

 

Competition

 

We are headquartered in Northern Virginia, where thereis a growing but limited community bank presence.  It is a community generally serviced by the branches of largeregional banks headquartered, for the most part, in cities outside NorthernVirginia.  Our market area is a highlycompetitive, highly branched banking market. We compete as a financial intermediary with other commercial banks,savings and loan associations, credit unions, mortgage banking firms, consumer financecompanies, securities brokerage firms, insurance companies, money market mutualfunds and other financial institutions operating in the Northern Virginiamarket area and elsewhere.

 

Competition in the market area for loans to smallbusinesses and professionals is intense, and pricing is important.  Many of our competitors have substantiallygreater resources and lending limits than we do.  In addition many competitors offer services, such as extensivebranch networks that we currently do not provide.  Moreover, larger institutions operating in the Northern Virginiamarket have access to borrowed funds at lower costs than are available to us.

 

Deposit competition among institutions in the marketarea also is very strong.  As a result,it is possible that we will pay above-market rates to attract deposits.  According to a market share data obtainedfrom the FDIC, excluding deposits held by E*TRADE Bank, Capital One Bank andTreasury Bank , we held 1.28 % of total deposits in our target market as ofJune 30, 2002, compared to 0.83% as of June 30, 2001.  Banks headquartered in our target market area controlled just24.2% of local deposits as of June 30, 2002, up from 22.2 % in the prior year.  Deposit market share of banks’ headquartersoutside of our target market area declined from 77.8 % as of June 30, 2001 to75.8% as of June 30, 2002. By providing competitive products and morepersonalized service, local banks have been able to take market share fromtheir non-local competitors, a trend we see continuing and one we intend toexploit as part of our revised strategy.

 

Employees

 

At December 31, 2002, we had 118 full-time employeesand 18 part-time employees.  None of ouremployees are represented by any collective bargaining unit.

 

Government Supervision andRegulation

 

*General*

 

As a bank holdingcompany, we are subject to regulation under the Bank Holding Company Act of1956, as amended, and the examination and reporting requirements of the Boardof Governors of the Federal Reserve System. Other federal and state laws, including various consumer and compliancelaws, govern the activities of our bank subsidiary, the investments that itmakes and the aggregate amount of loans that it may grant to one borrower.  Our national bank subsidiary, Cardinal Bank,N.A., is subject to regulation, supervision and examination by the Office ofthe Comptroller of the Currency.  Ourbank subsidiary also is subject to regulation, supervision and examination bythe Federal Deposit Insurance Corporation.

 

The following description summarizes the significantfederal and state laws applicable to us. To the extent that statutory or regulatory provisions are described, thedescription is qualified in its entirety by reference to that particularstatutory or regulatory provision.

 

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*The Bank Holding Company Act*

 

Under the Bank HoldingCompany Act, we are subject to periodic examination by the Federal Reserve andrequired to file periodic reports regarding our operations and any additionalinformation that the Federal Reserve may require.  Our activities at the bank holding company level are limited to:

 

•                  banking,managing or controlling banks;

•                  furnishingservices to or performing services for our subsidiary and

•                  engaging in otheractivities that the Federal Reserve has determined by regulation or     order to be so closely relatedto banking as to be a proper incident to these activities.

 

Some of the activities that the Federal Reserve Boardhas determined by regulation to be proper incidents to the business of a bankholding company include making or servicing loans and specific types of leases,performing specific data processing services and acting in some circumstancesas a fiduciary or investment or financial adviser.

 

With some limitedexceptions, the Bank Holding Company Act requires every bank holding company toobtain the prior approval of the Federal Reserve before:

 

•                  acquiringsubstantially all the assets of any bank;

•                  acquiring director indirect ownership or control of any voting shares of any bank if after suchacquisition it would own or control more than 5% of the voting shares of suchbank (unless it already owns or controls the majority of such shares); or

•                  merging orconsolidating with another bank holding company.

 

In addition, and subjectto some exceptions, the Bank Holding Company Act and the Change in Bank ControlAct, together with their regulations, require Federal Reserve approval prior toany person 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 theGramm-Leach-Bliley Act, which made substantial revisions to the statutoryrestrictions separating banking activities from other financial activities.  Under the GLBA, bank holding companies thatare well-capitalized and well-managed and meet other conditions can elect tobecome “financial holding companies.” As financial holding companies, they and their subsidiaries arepermitted to acquire or engage in previously impermissible activities such asinsurance underwriting, securities underwriting and distribution, travel agencyactivities, insurance agency activities, merchant banking and other activitiesthat the Federal Reserve determines to be financial in nature or complementaryto these activities.  Financial holdingcompanies continue to be subject to the overall oversight and supervision ofthe Federal Reserve, but the GLBA applies the concept of functional regulationto the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision andregulation by state insurance authorities. Although we have not elected to become a financial holding company inorder to exercise the broader activity powers provided by the GLBA, we willlikely do so in the future.

 

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*Payment of Dividends*

 

We are a legal entityseparate and distinct from our banking and other subsidiaries.  Virtually all of our revenues will result fromdividends paid to us by our bank subsidiary. Our bank subsidiary is subject to laws and regulations that limit theamount of dividends that it can pay. Under OCC regulations, a national bank may not declare a dividend inexcess of its undivided profits, which means that our national bank subsidiarymust recover any 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.  Our nationalbank subsidiary may not declare or pay any dividend if, after making thedividend, the national bank would be “undercapitalized,” as defined in thefederal regulations.

 

The FDIC has the generalauthority to limit the dividends paid by insured banks if the payment is deemedan unsafe and unsound practice.  TheFDIC has indicated that paying dividends that deplete a bank’s capital base toan inadequate level would be an unsound and unsafe banking practice.

 

In addition, both we and our bank subsidiary aresubject to various regulatory restrictions relating to the payment ofdividends, including requirements to maintain capital at or above regulatoryminimums.  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, Assessmentsand Regulation by the FDIC*

 

The deposits of our banksubsidiary is 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 depositinsurance assessment system under which the assessment rate for an insuredinstitution may vary according to regulatory capital levels of the institutionand other factors, including supervisory evaluations.  For example, depository institutions insured by the BIF that are“well capitalized” and that present few or no supervisory concerns are requiredto pay only the statutory minimum assessment of $2,000 annually for depositinsurance, while all other banks are required to pay premiums ranging from .03%to .27% of domestic deposits.  Theserate schedules are subject to future adjustments by the FDIC. In addition, theFDIC has authority to impose special assessments from time to time.

 

The FDIC is authorized to prohibit any BIF-insuredinstitution from engaging in any activity that the FDIC determines byregulation or order to pose a serious threat to the respective insurancefund.  Also, the FDIC may initiateenforcement actions against banks, after first giving the institution’s primaryregulatory authority an opportunity to take such action.  The FDIC may terminate the deposit insuranceof any depository institution if it determines, after a hearing, that 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 

 

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period from six months to two years, as determined by the FDIC.  We are not aware of any existingcircumstances that could result in termination of any of our bank subsidiarydeposit 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 is defined as common equity, retainedearnings and qualifying perpetual preferred stock, less certainintangibles.  The remainder may consistof  “Tier 2 Capital”, which is definedas specific subordinated debt, some hybrid capital instruments and otherqualifying preferred stock and a limited amount of the loan lossallowance.  In addition, each of thefederal banking regulatory agencies has established minimum leverage capitalrequirements for banking organizations. Under these requirements, banking organizations must maintain a minimumratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%,subject to federal bank regulatory evaluation of an organization’s overallsafety and soundness.  In sum, thecapital measures used by the federal banking regulators are:

 

•                  the TotalCapital ratio, which is the total of Tier 1 Capital and Tier 2 Capital;

 

•                  the Tier 1Capital ratio; and

 

•                  the leverageratio.

 

Underthese regulations, a bank will be:

 

•                  “wellcapitalized” if it has a Total Capital ratio of 10% or greater, a Tier 1Capital ratio of 6% or greater, and is not subject to any written agreement,order, capital directive, or prompt corrective action directive by a federalbank regulatory agency to meet and maintain a specific capital level for anycapital measure;

 

•                  “adequatelycapitalized” if it has a Total Capital ratio of 8% or greater, a Tier 1Capital 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 a Total Capital ratio of less than 8% or greater, a Tier 1 Capitalratio of less than 4% - or 3% in certain circumstances;

 

•                  “significantlyundercapitalized” if it has a Total Capital ratio of less than 6%, aTier 1 Capital ratio of less than 3%, or a leverage ratio of less than 3%;or

 

•                  “criticallyundercapitalized” if its tangible equity is equal to or less than 2% of averagequarterly tangible assets.

 

The risk-based capital standards of each of the OCCand the Federal Reserve Board explicitly identify concentrations of credit riskand the risk arising from non-traditional activities, as well as aninstitution’s ability to manage these risks, as important factors to be takeninto account by the agency in assessing an institution’s overall capitaladequacy.  The capital guidelines alsoprovide that an institution’s exposure to a decline in the economic value ofits capital due to changes in interest rates be considered by the agency as afactor in evaluating a banking organization’s capital adequacy.

 

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The OCC and the FDIC maytake various corrective actions against any undercapitalized bank and any bankthat fails to submit an acceptable capital restoration plan or fails toimplement a plan accepted by the OCC or the FDIC.  These powers include, but are not limited to, requiring theinstitution to be recapitalized, prohibiting asset growth, restricting interestrates paid, requiring prior approval of capital distributions by any bankholding company that controls the institution, requiring divestiture by theinstitution of its subsidiaries or by the holding company of the institutionitself, requiring new election of directors, and requiring the dismissal ofdirectors and officers.  Our banksubsidiary presently maintains sufficient capital to remain in compliance withthese capital requirements.

 

*Other Safety and SoundnessRegulations*

 

There are a number ofobligations and restrictions imposed on bank holding companies and theirdepository institution subsidiaries by federal law and regulatory policy thatare designed to reduce potential loss exposure to the depositors of suchdepository institutions and to the FDIC insurance funds in the event that thedepository institution is insolvent or is in danger of becoming insolvent.  For example, under the requirements of theFederal Reserve Board with respect to bank holding company operations, a bankholding company is required to serve as a source of financial strength to itssubsidiary depository institutions and to commit resources to support suchinstitutions in circumstances where it might not do so otherwise.  In addition, the “cross-guarantee”provisions of federal law require insured depository institutions under commoncontrol to reimburse the FDIC for any loss suffered or reasonably anticipatedby the FDIC as a result of the insolvency of commonly controlled insureddepository institutions or for any assistance provided by the FDIC to commonlycontrolled insured depository institutions in danger of failure.  The FDIC may decline to enforce thecross-guarantee provision if it determines that a waiver is in the bestinterests of the deposit insurance funds. The FDIC’s claim for reimbursement under the cross guarantee provisionsis superior to claims of shareholders of the insured depository institution orits holding company but is subordinate to claims of depositors, securedcreditors and nonaffiliated holders of subordinated debt of the commonlycontrolled insured depository institutions.

 

*Interstate Banking and Branching*

 

Current federal lawauthorizes interstate acquisitions of banks and bank holding companies withoutgeographic limitation.  EffectiveJune 1, 1997, a bank headquartered in one state is authorized to mergewith a bank headquartered in another state, as long as neither of the stateshad opted out of such interstate merger authority prior to such date.  After a bank has established branches in astate through an interstate merger transaction, the bank may establish andacquire additional branches at any location in the state where a bankheadquartered in that state could have established or acquired branches underapplicable federal or state law.

 

*Monetary Policy*

 

The commercial bankingbusiness is affected not only by general economic conditions but also by themonetary policies of the Federal Reserve Board.  The instruments of monetary policy employed by the FederalReserve Board include open market operations in United States governmentsecurities, changes in the discount rate on member bank borrowing and changes inreserve requirements against deposits held by all federally insured banks.  The Federal Reserve Board’s monetarypolicies have had a significant effect on the operating results of commercialbanks in the past and are expected to continue to do so in the future.  In view of changing conditions in thenational and international economy and in the money markets, as well as theeffect of actions by monetary fiscal authorities, including the Federal ReserveBoard, no prediction can be made as to possible future changes in interestrates, deposit levels, loan demand or the business and earnings of our banksubsidiary.

 

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*Federal Reserve System*

 

In 1980, Congress enactedlegislation that imposed reserve requirements on all depository institutionsthat maintain transaction accounts or nonpersonal time deposits.  NOW accounts, money market deposit accountsand other types of accounts that permit payments or transfers to third partiesfall within the definition of transaction accounts and are subject to thesereserve requirements, as are any nonpersonal time deposits at aninstitution.  For net transactionaccounts in 2002, the first $5.7 million will be exempt from reserverequirements.  A 3% reserve ratio willbe assessed on net transaction accounts over $5.7 million to and including$41.3 million.  A 10% reserve ratio willbe applied to net transaction accounts in excess of $41.3 million.  These percentages are subject to adjustmentby the Federal Reserve Board.  Becauserequired reserves must be maintained in the form of vault cash or in anon-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 betweenbanks and their affiliates are governed by Sections 23A and 23B of the FederalReserve Act.  An affiliate of a bank isany bank or entity that controls, is controlled by or is under common controlwith such bank.  Generally, Sections 23Aand 23B (i) limit the extent to which the bank or its subsidiaries may engagein “covered transactions” with any one affiliate to an amount equal to 10% ofsuch institution’s capital stock and surplus, and maintain an aggregate limiton all such transactions with affiliates to an amount equal to 20% of suchcapital stock and surplus, and (ii) require that all such transactions be onterms substantially the same, or at least as favorable, to the association orsubsidiary as those provided to a nonaffiliate.  The term “covered transaction” includes the making of loans,purchase of assets, issuance of a guarantee and similar other types oftransactions.

 

*Loans to Insiders*

 

The Federal Reserve Actand related regulations impose specific restrictions on loans to directors,executive officers and principal shareholders of banks.  Under Section 22(h) of the Federal ReserveAct, loans to a director, an executive officer and to a principal shareholderof a bank, and some affiliated entities of any of the foregoing, may notexceed, together with all other outstanding loans to such person and affiliatedentities, the bank’s loan-to-one borrower limit.  Loans in the aggregate to insiders and their related interests asa class 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 prohibits loans,above amounts prescribed by the appropriate federal banking agency, todirectors, executive officers and principal shareholders of a bank or bankholding company, and their respective affiliates, unless such loan is approvedin advance by a majority of the board of directors of the bank with any“interested” director not participating in the voting.  The FDIC 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 CommunityReinvestment Act and related regulations, depository institutions have anaffirmative obligation to assist in meeting the credit needs of their marketareas, including low and moderate-income areas, consistent with safe and soundbanking practice.  The CommunityReinvestment 

 

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Act requires the adoptionby each institution of a Community Reinvestment Act statement for each of itsmarket areas 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.

 

The Gramm-Leach-Bliley Act and federal bank regulatorshave made various changes to the Community Reinvestment Act.  Among other changes, Community ReinvestmentAct agreements with private parties must be disclosed and annual reports mustbe made to a bank’s primary federal regulatory. A bank holding company will notbe permitted to become a financial holding company and no new activitiesauthorized under the GLBA may be commenced by a holding company or by a bankfinancial subsidiary if any of its bank subsidiaries received less than a“satisfactory” rating in its latest Community Reinvestment Act examination.

 

*Fair Lending; Consumer Laws*

 

In addition to theCommunity Reinvestment Act, other federal and state laws regulate variouslending and consumer aspects of the banking business.  Governmental agencies, including the Department of Housing andUrban Development, the Federal Trade Commission and the Department of Justice,have become concerned that prospective borrowers experience discrimination intheir efforts to obtain loans from depository and other lending institutions.  These agencies have brought litigationagainst depository institutions alleging discrimination against borrowers.  Many of these suits have been settled, insome cases for material sums, short of a full trial.

 

Recently, thesegovernmental agencies have clarified what they consider to be lendingdiscrimination and have specified various factors that they will use todetermine 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 otherdepository institutions also are subject to numerous consumer-oriented laws andregulations.  These laws, which includethe Truth 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-BlileyAct of 1999  was signed into law onNovember 12, 1999.  The GLBA covers abroad range of issues, including a repeal of most of the restrictions onaffiliations among depository institutions, securities firms and insurancecompanies.  Most of its provisionsrequire the federal bank regulatory agencies and other regulatory bodies toadopt implementing regulations, and for that reason an assessment of the fullimpact of the GLBA on us must await completion of that regulatory process.  The following description summarizes some ofits significant provisions.

 

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The GLBA repeals sections 20 and 32 of the Glass-SteagallAct, thus permitting unrestricted affiliations between banks and securitiesfirms.  It also permits bank holdingcompanies to elect to become financial holding companies.  A financial holding company may engage in oracquire companies that engage in a broad range of financial services, includingsecurities activities such as underwriting, dealing, investment, merchantbanking, insurance underwriting, sales and brokerage activities.  In order to become a financial holdingcompany, the bank holding company and all of its affiliated depositoryinstitutions must be well-capitalized, well-managed and have at least a satisfactoryCommunity Reinvestment Act rating.

 

The GLBA provides that the states continue to have theauthority to regulate insurance activities, but prohibits the states in mostinstances from preventing or significantly interfering with the ability of abank, directly or through an affiliate, to engage in insurance sales,solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities ina nondiscriminatory 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 regulationunder which the Federal Reserve Board is designated as the umbrella regulatorfor financial holding companies, but financial holding company affiliates areprincipally regulated by functional regulators such as the FDIC for statenonmember bank affiliates, the Securities and Exchange Commission forsecurities affiliates, and state insurance regulators for insuranceaffiliates.  It repeals the broadexemption of banks from the definitions of “broker” and “dealer” for purposesof the Securities Exchange Act of 1934, as amended.  It also identifies a set of specific activities, includingtraditional bank trust and fiduciary activities, in which a bank may engagewithout being deemed a “broker,” and a set of activities in which a bank mayengage without being deemed a “dealer.” Additionally, the new law makes conforming changes in the definitions of“broker” and “dealer” for purposes of the Investment Company Act of 1940, asamended, and the Investment Advisers Act of 1940, as amended.

 

The GLBA contains extensive customer privacyprotection provisions.  Under theseprovisions, a financial institution must provide to its customers, both at theinception of the customer relationship and on an annual basis, theinstitution’s policies and procedures regarding the handling of customers’nonpublic personal financial information. The new law provides that, except for specific limited exceptions, aninstitution may not provide such personal information to unaffiliated thirdparties unless the institution discloses to the customer that such informationmay be so provided and the customer is given the opportunity to opt out of suchdisclosure.  An institution may notdisclose to a non-affiliated third party, other than to a consumer reportingagency, customer account numbers or other similar account identifiers formarketing purposes.  The GLBA alsoprovides that the states may adopt customer privacy protections that are morestrict than those contained in the act.

 

*Future Regulatory Uncertainty*

 

Because federalregulation of financial institutions changes regularly and is the subject ofconstant legislative debate, we cannot forecast how federal regulation offinancial institutions may change in the future and impact our operations.  Although Congress in recent years has soughtto reduce the regulatory burden on financial institutions with respect to theapproval of specific transactions, we fully expect that the financialinstitution industry will remain heavily regulated in the near future and thatadditional laws or regulations may be adopted further regulating specificbanking practices.

 

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**Item2.****           Descriptionof Property**

 

We conduct our businessfrom our main office in McLean, Virginia and eight branch banking offices.  The following table provides certaininformation with respect to our properties:

 
| **Location:**                                                                                              |   | **Date  Facility Opened:** |   | **Ownership  and Leasing Arrangements**                                                                                                                  |
|------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| Main Office:   Cardinal Financial Corporation   8270 Greensboro Drive   Suite 500   McLean, Virginia 22102 |   | March, 2003                |   | We occupy approximately  20,600 square feet under a sublease that expires February 28, 2010.                                                             |
|                                                                                                       |   |                       |   |                                                                                                                                                     |
| Branch Office #1   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.  |
|                                                                                                       |   |                       |   |                                                                                                                                                     |
| Also at the location  is:   Cardinal Wealth Services, Inc                                                  |   |                       |   | Cardinal Wealth  Services, Inc. occupies 700 square feet under the same lease as the branch  office.                                                     |
|                                                                                                       |   |                       |   |                                                                                                                                                     |
| Branch Office #2   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 #3   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 #4   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 29, 2009.                                                      |
|                                                                                                       |   |                       |   |                                                                                                                                                     |
| Branch Office #5   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 #6   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.                                                         |

 

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| Branch Office #7   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. |
|-----------------------------------------------------------------------------------------|--------|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                    |   |            |   |                                                                                                                                                                   |
| Branch Office #8   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.                                                                      |

 

We have standard renewalprovisions in all our lease agreements with the exception of our main officelocation.  We believe that all of ourproperties are maintained in good operating condition and are suitable andadequate for our operational needs.

 

**Item3.****           LegalProceedings**

 

In the ordinary course ofour operations, we may become party to legal proceedings.  Currently, we are not party to any materialproceedings and no such proceedings are, to management’s knowledge, threatenedagainst us.

 

**Item4.****           Submissionof Matters to a Vote of Security Holders**

 

                                                Nomatters were submitted to a vote of security holders, through the solicitationof proxies or otherwise, during the fourth quarter of 2002.

 

**PARTII**

 

**Item5.****           Marketfor Common Equity and Related Stockholder Matters**

 

Our common shares are traded on the Nasdaq SmallCapMarket under the symbol “CFNL.”  Thefollowing table sets forth the high and low bid information for our shares onthe NASDAQ SmallCap Market for the periods indicated

 
| **Periods Ended**   |   | **High** |   | **Low** |   |
|---------------------|--------|----------|--------|---------|--------|
| 2000                |   |     |   |    |   |
| First  Quarter      |   | $        | 4.75   |    | $      | 4.50 |   |
| Second  Quarter     |   | 5.25     |   | 5.06    |   |
| Third  Quarter      |   | 5.13     |   | 4.13    |   |
| Fourth  Quarter     |   | 3.88     |   | 3.25    |   |
| 2001                |   |     |   |    |   |
| First  Quarter      |   | 4.88     |   | 3.50    |   |
| Second  Quarter     |   | 5.96     |   | 4.25    |   |
| Third  Quarter      |   | 6.69     |   | 5.18    |   |
| Fourth  Quarter     |   | 6.60     |   | 5.90    |   |
| 2002                |   |     |   |    |   |
| First  Quarter      |   | 4.00     |   | 3.90    |   |
| Second  Quarter     |   | 4.85     |   | 4.70    |   |
| Third  Quarter      |   | 4.16     |   | 4.11    |   |
| Fourth  Quarter     |   | 4.40     |   | 4.34    |   |
| 2003                |   |     |   |    |   |
| January  - March 11 |   | 5.45     |   | 4.30    |   |
|                     |        |          |        |         |        |  |  |

 

Our 10,044,345 commonshares outstanding as of December 31, 2002 were held by approximately 1,741holders of record.

 

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We have not declared or distributed any cash dividendsto the holders of our common shares, and it is not likely that we will declareany cash dividends on our common shares in the foreseeable future.  A dividend accrues on the Series A 7.25%Cumulative Convertible Preferred Stock at the rate of $0.3625 per share perannum.  This dividend is payable, at thediscretion of the board of directors, on a quarterly basis.  To date we have paid the dividend to theholders of the Series A 7.25% Cumulative Convertible Preferred Stock.  Our board of directors intends to follow apolicy of retaining any earnings to provide funds to operate and expand ourbusiness for the foreseeable future. Our future dividend policy is subject to the discretion of the board ofdirectors and will depend upon a number of factors, including future earnings,financial condition, cash requirements, and general business conditions.

 

Our ability to distribute cash dividends will dependprimarily on the abilities of our subsidiaries to pay dividends to us.  As a national bank, Cardinal Bank is subjectto legal limitations on the amount of dividends it is permitted to pay.  Furthermore, neither Cardinal Bank nor wemay declare or pay a cash dividend on any of our capital stock if we areinsolvent or if the payment of the dividend would render us insolvent or unableto pay our obligations as they become due in the ordinary course ofbusiness.  For additional information onthese limitations, see “Government Regulation and Supervision — Payment ofDividends” in Item 1 above.

 

**Item6.****           Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following presentsmanagement’s discussion and analysis of our consolidated financial conditionfor the years ended December 31, 2002 and 2001 and the results of ouroperations for the years ended December 31, 2002, 2001 and 2000.  The discussion should be read in conjunctionwith the accompanying consolidated financial statements.

 

**Company Overview**

 

Cardinal FinancialCorporation is a locally owned and managed financial services organizationheadquartered in Northern Virginia and committed to providing top qualitycustomer service, a diversified product mix and convenient avenues for bankingto consumers and businesses.  During2002, total assets increased 74.0% to $486.3 million.  As of December 31, 2002, net loans receivable increased 24.2% to$245.7 million.  In just over four yearsof operations, we have become one of the largest banks headquartered in ourmarket measured by deposits.  Totaldeposits increased 72.1% to $423.5 million as of December 31, 2002.  Our investment advisory subsidiary, CardinalWealth Services, Inc., ended 2002 with over 2,000 customers and assets undermanagement exceeding $98.8 million.

 

**Critical Accounting Policies**

 

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

 

We maintain the allowancefor loan losses at a level that represents management’s best estimate of knownand inherent losses in the loan portfolio. Both the amount of the provision expense 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. As a part of our analysis, we use comparative peer group data, durationfactors and qualitative factors such as levels of and trends in delinquenciesand nonaccrual loans, national and local economic trends and conditions andconcentrations of loans exhibiting similar risk profiles to support our estimates.  The loan loss provision for the years endedDecember 31, 2002, 2001 and 2000 was $444,000, $1.2 million and $753,000,respectively.  The allowance for loanloss increased slightly to $3.4 million as of December 31, 2002 from $3.1million as of December 31, 2001.  Theratio of the allowance for loan losses to total loans, 

 

21

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net of fees, was 1.35% atDecember 31, 2002 compared to 1.54% at December 31, 2001.  Additional information on the allowance forloan losses and provision expense can be found later in this discussion under“Provision Expense and Allowance for Loan Losses.”

 

Credit losses are aninherent part of our business and, although we believe the methodologies fordetermining the allowance for loan losses and the current level of theallowance are adequate, it is possible that there may be unidentified losses inthe portfolio that may become evident only at a future date.  Additional provisions for such losses, ifnecessary, would negatively impact earnings and would be recorded in thebanking business segment.

 

We categorize our loansinto one of five pools:  commercial andindustrial, commercial real estate, home equity lines of credit, residentialmortgages, and consumer loans.  Peer groupannual loss factors (in the absence of historical results) are applied to allpools and are adjusted by the projected duration of the loan pool and by thequalitative factors mentioned above. The indicated loss factors resulting from this analysis are applied toeach of the loan pools to determine a reserve level for each of the five poolsof loans.  In addition, we individuallyassign loss factors to all loans that have been identified as having lossattributes, as indicated by deterioration in the financial condition of theborrower or a decline in underlying collateral values.  Since we have limited historical data onwhich to base loss factors for classified loans, we apply a 5% loss factor toall special mention loans and a 15% loss factor to all substandard loans (inaccordance with regulatory guidelines).

 

*Valuation Allowance for Deferred TaxAssets*

 

Deferred income taxesreflect temporary differences in the recognition of revenue and expenses fortax reporting and financial statement purposes, principally because certainitems, such as depreciation and amortization, are recognized in differentperiods for financial reporting and tax return purposes.  A valuation allowance has been establishedfor deferred tax assets, as realization is dependent upon generating futuretaxable income. Additional information on the valuation allowance can be foundin Footnote 9 to the Notes to Consolidated Financial Statements.

 

*New Financial Accounting Standards*

 

During 2002, theFinancial Accounting Standards Board issued several new accountingpronouncements which are summarized below. These new pronouncements have had no impact on our financial results norare they expected to have a material impact.

 

SFAS No. 145, “Rescissionof FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, andTechnical Corrections,” was issued in May 2002.  SFAS No. 145 rescinds FASB Statement No. 4, “Reporting Gains andLosses from Extinguishment of Debt,” as well as an amendment of that Statement,FASB Statement No. 64, “Accounting for Intangible Assets of Motor Carriers,”and amends FASB Statement No. 13, “Accounting for Leases,” to eliminate aninconsistency between the required accounting for sale-leaseback transactionsand the required accounting for certain lease modifications that have economiceffects that are similar to sale-leaseback transactions.  In addition, SFAS No. 145 amends otherexisting authoritative pronouncements to make various technical corrections,clarify meanings, or describe their applicability under changed conditions.

 

SFAS No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities,” was issued in June2002.  It addresses financial accountingand reporting for costs associated with exit or disposal activities and nullifiesEmerging Issues Task Force EITF Issue 94-3 (EITF 94-3), “Liability Recognitionfor Certain Employee Termination Benefits and Other Costs to Exit anActivity.”  Unlike EITF 94-3, SFAS 

 

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No. 146 requires that aliability for a cost associated with an exit or disposal activity be recognizedwhen that liability is incurred rather than at the date of an entity’scommitment to an exit plan.

 

SFAS No. 147,“Acquisitions of Certain Financial Institutions,” amends FASB Statement No. 72and 144 and FASB Interpretation No. 9, and was issued in July 2002.  In removes acquisitions of financialinstitutions from the scope of both Statement No. 72 and Interpretation No. 9,except for transactions between two or more mutual enterprises.  Instead, it requires that acquisitions offinancial institutions be accounted for in accordance with SFAS No. 141,“Business Combinations,” and SFAS No. 142, “Goodwill and Other IntangibleAssets.”

 

SFAS No. 148, “Accountingfor Stock-Based Compensation- Transition and Disclosure, an amendment of FASBStatement No. 123,” was issued in December 2002.  It amends SFAS No. 123, “Accounting for Stock BasedCompensation,” to provide alternative methods of transition for an entity thatvoluntarily adopts the fair value based method of accounting for stock-basedemployee compensation.  It also amendsthe disclosure provision of SFAS No. 123 to require prominent disclosure aboutthe effects on reported net income of an entity’s accounting policy decisionswith respect to stock-based employee compensation.  Finally, this statement amends APB Opinion 28, “Interim FinancialReporting,” to require disclosure about those effects in interim financialinformation.

 

 

23

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**SelectedFinancial Information**

(Dollars in thousands,except share and per share data)

 
|                                                 |   | **For the  Years Ended December 31,** |    |
|------------------------------------------------------|--------|---------------------------------------|---------|
| **Results of Operations**                            |   | **2002**                              |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Interest and  dividend income                        |   | $                                     | 20,242  |   | $ | 16,577 |   | $ | 11,150 |   | $ | 4,330 |   | $ | 1,556 |   |
| Interest expense                                     |   | 9,586                                 |    | 7,500 |   | 4,740 |   | 1,305 |   | 340 |   |
| Net interest  income                                 |   | 10,656                                |    | 9,077 |   | 6,410 |   | 3,025 |   | 1,216 |   |
| Provision for  loan losses                           |   | 444                                   |    | 1,202 |   | 753 |   | 514 |   | 212 |   |
| Net interest  income after provision for loan losses |   | 10,212                                |    | 7,875 |   | 5,657 |   | 2,511 |   | 1,004 |   |
| Non-interest  income                                 |   | 3,273                                 |    | 3,267 |   | 2,098 |   | 1,320 |   | 34 |   |
| Non-interest  expense                                |   | 14,014                                |    | 23,866 |   | 11,726 |   | 7,870 |   | 2,734 |   |
| Net loss before  income taxes                        |   | (529                                  | )       | (12,724 | ) | (3,971 | ) | (4,039 | ) | (1,696 | ) |
| Provision for  income taxes                          |   | —                                |    | — |   | — |   | — |   | — |   |
| Net loss                                             |   | (529                                  | )       | (12,724 | ) | (3,971 | ) | (4,039 | ) | (1,696 | ) |
| Dividends to  preferred shareholders                 |   | 495                                   |    | 503 |   | 171 |   | — |   | — |   |
| Net loss to  common shareholders                     |   | (1,024                                | )       | (13,227 | ) | (4,142 | ) | (4,039 | ) | (1,696 | ) |
|                                                 |   |                                  |    |   |   |   |   |   |   |   |   |
| **Loss  Per Common Share**                           |   |                                  |    |   |   |   |   |   |   |   |   |
| Basic &  diluted:                                |   |                                  |    |   |   |   |   |   |   |   |   |
| Net loss                                             |   | $                                     | (0.13   | ) | $ | (3.11 | ) | $ | (0.98 | ) | $ | (0.95 | ) | $ | (0.64 | ) |
| Average shares  outstanding                          |   | 7,949,132                             |    | 4,258,087 |   | 4,246,346 |   | 4,240,819 |   | 2,646,036 |   |
| Dividends paid  per common share                     |   | $                                     | —  |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| **Financial  Condition**                             |   |                                  |    |   |   |   |   |   |   |   |   |
|                                                 |   |                                  |    |   |   |   |   |   |   |   |   |
| **Selected  Average Balances**                       |   |                                  |    |   |   |   |   |   |   |   |   |
| Total assets                                         |   | $                                     | 388,826 |   | $ | 242,732 |   | $ | 146,093 |   | $ | 71,987 |   | $ | 31,604 |   |
| Earning assets                                       |   | 365,269                               |    | 217,881 |   | 132,863 |   | 65,945 |   | 26,925 |   |
| Loans  receivable, net                               |   | 203,594                               |    | 178,901 |   | 102,785 |   | 33,265 |   | 1,948 |   |
| Deposits                                             |   | 348,141                               |    | 197,434 |   | 105,931 |   | 36,132 |   | 8,347 |   |
| Other borrowed  funds                                |   | 5,564                                 |    | 10,002 |   | 6,904 |   | 1,773 |   | — |   |
| Total  shareholders’ equity                     |   | 32,839                                |    | 32,506 |   | 31,215 |   | 32,942 |   | 22,783 |   |
|                                                 |   |                                  |    |   |   |   |   |   |   |   |   |
| **At  December 31**                                  |   |                                  |    |   |   |   |   |   |   |   |   |
| Total assets                                         |   | $                                     | 486,323 |   | $ | 279,584 |   | $ | 207,048 |   | $ | 97,033 |   | $ | 57,295 |   |
| Earning assets                                       |   | 450,292                               |    | 264,071 |   | 187,281 |   | 89,563 |   | 54,317 |   |
| Loans  receivable, net                               |   | 245,734                               |    | 197,807 |   | 152,371 |   | 67,441 |   | 16,115 |   |
| Deposits                                             |   | 423,479                               |    | 246,024 |   | 163,371 |   | 59,873 |   | 21,867 |   |
| Other borrowed  funds                                |   | 2,000                                 |    | 9,824 |   | 7,287 |   | 6,000 |   | — |   |
| Total  shareholders’ equity                     |   | 40,712                                |    | 20,624 |   | 34,112 |   | 30,745 |   | 34,728 |   |
| **Selected  Ratios and Other Data**                  |   |                                  |    |   |   |   |   |   |   |   |   |
| Return on  average assets                            |   | —0.14                            | %       | —5.24 | % | —2.72 | % | —5.61 | % | —5.37 | % |
| Return on  average equity                            |   | —1.61                            | %       | —39.14 | % | —12.72 | % | —12.26 | % | —7.44 | % |
| Net interest  margin                                 |   | 2.92                                  | %       | 4.17 | % | 4.82 | % | 4.59 | % | 4.66 | % |
| Net interest  spread                                 |   | 2.27                                  | %       | 2.90 | % | 2.85 | % | 2.30 | % | 1.09 | % |
| Total shareholders’  equity to total assets     |   | 8.37                                  | %       | 7.38 | % | 16.48 | % | 31.69 | % | 60.61 | % |
| Allowance to  year end loans                         |   | 1.35                                  | %       | 1.54 | % | 1.23 | % | 1.07 | % | 1.30 | % |
| Non-performing  assets to total loans                |   | 0.37                                  | %       | 0.18 | % | 0.38 | % | 0.00 | % | 0.00 | % |
| Based on  averages:                                  |   |                                  |    |   |   |   |   |   |   |   |   |
| Total equity to  total assets                        |   | 8.45                                  | %       | 13.39 | % | 21.37 | % | 45.76 | % | 72.09 | % |
| Total loans to  total equity                         |   | 629.29                                | %       | 556.88 | % | 333.07 | % | 102.23 | % | 8.65 | % |
| Full-time  equivalent employees                      |   | 107                                   |    | 100 |   | 131 |   | 82 |   | 30 |   |

 

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**2002 Compared to 2001**

 

Our net loss for the year ended December 31, 2002 totaled$1.0 million or $0.13 per common share, compared with a loss of $13.2 millionor $3.11 per common share for the same period of 2001.  Included in the reported net loss for theyear ended December 31, 2002 were two quarters (3rd and 4thquarters) of net income totaling $390,000 or $0.04 per common share. The 2002loss included an impairment of $1.7 million of an investment in a WorldCombond.  If the impact of the WorldComimpairment were excluded, we would have reported net income of $636,000, or$0.08 per common share for the year ended December 31, 2002 (see Table 1 for areconciliation of GAAP to Non-GAAP Financial Measures).  All year-end results are presented after theeffect of dividends paid to preferred shareholders of $495,000 and $503,000 forthe years ended December 31, 2002 and 2001, respectively.  The return on average assets for the yearsended December 31, 2002, 2001 and 2000 were (0.14%),  (5.24%) and (2.72%), respectively.  The return on average equity for the years ended December 31,2002, 2001 and 2000 were (1.61%), (39.14%) and (12.72%), respectively.

 

Total assets 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 deposit growth of $177.5 million,or 72.1%, to $423.5 million at December 31, 2002.  The strong growth experienced during 2002 is attributed toaggressive promotion of our products through advertising and direct mail inaddition to opening our eighth branch in Arlington, Virginia during the fourthquarter of 2002.

 

Total shareholders’equity increased $20.1 million or 97.4% to $40.7 million at December 31, 2002compared to $20.6 million at December 31, 2001.  This increase was primarily a result of our successful $18.5million rights and secondary offerings during the second quarter of 2002.  Book value per common share increased to$3.37 at December 31, 2002 compared to $3.21 at December 31, 2001.  The ratio of total capital to risk basedassets increased to 13.35% at December 31, 2002 compared to 10.42% at December31, 2001 giving us a well-capitalized position for regulatory purposes goinginto 2003.  Total shareholders’ equityto total assets at December 31, 2002, 2001 and 2000 were 8.4%, 7.4% and 16.5%,respectively.

 

**Table 1.**

 

**Reconciliationof GAAP to Non-GAAP Financial Measures**

Years ended December 31,2002, 2001 and 2000

(Dollars in thousands,except per share data)

 
|                                                            |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Reported net  loss to common shareholders                       |   | $        | (1,024 | )        | $      | (13,227  | )      | $ | (4,142 | ) |
| Less  nonrecurring expenses:                                    |   |     |   |     |   |     |   |
| Writedown of  WorldCom bond                                     |   | 1,660    |   | —   |   | —   |   |
| Impairment of  Heritage Bancorp goodwill                        |   | —   |   | 8,264    |   | —   |   |
| Restructuring  costs                                            |   | —   |   | 884      |   | —   |   |
| Net income  (loss) without nonrecurring expenses                |   | $        | 636    |     | $      | (4,079   | )      | $ | (4,142 | ) |
|                                                            |   |     |   |     |   |     |   |
| Reported net  loss per common share                             |   | $        | (0.13  | )        | $      | (3.11    | )      | $ | (0.98 | ) |
| Less  nonrecurring expenses:                                    |   |     |   |     |   |     |   |
| Writedown of  WorldCom bond                                     |   | 0.21     |   | —   |   | —   |   |
| Impairment of  Heritage Bancorp goodwill                        |   | —   |   | 1.94     |   | —   |   |
| Restructuring  costs                                            |   | —   |   | 0.21     |   | —   |   |
| Earnings (loss)  per common share without nonrecurring expenses |   | $        | 0.08   |     | $      | (0.96    | )      | $ | (0.98 | ) |

 

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**Statements of Operations**

 

*Net Interest Income/Margin*

 

Net interest income isour primary source of revenue, representing the difference between interest andfees earned on interest-bearing assets and the interest paid on deposits andother interest-bearing liabilities.  Thelevel of net interest income is impacted primarily by variations in the volumeand mix of these assets and liabilities, as well as changes in interest rateswhen compared to previous periods of operations.  During 2002, we continued to experience a weakened economy that hadentered into a recessionary phase early in 2001. During 2001, the FederalReserve lowered rates eleven times in order to turn the economy around from itsrecessionary phase.  During the fourthquarter of 2002, in response to this weakening economy and the lack of anyinflationary pressures, the Federal Reserve lowered rates an additional 50basis points.  At 4.25%, the primelending rate is at its lowest levels in over forty years. We expect that 2003will be another year of slow economic growth in the financial markets withlittle to no change in interest rates.

 

Net interest income was$10.7 million in 2002, up $1.6 million or 17.4% from 2001.  The increase is primarily due to theincrease in loans and investment securities available-for-sale during 2002,funded through the increase in total deposits and shareholders’ equity.  The increase in net interest income wastempered by a reduction in our net interest margin, due primarily to thecontinued decline in yields on earnings assets at a faster pace than thedecline in yields on interest bearing liabilities.

 

The net interest marginwas 2.92% for the year ended December 31, 2002 as compared to 4.17% for thesame period of 2001.   The decrease inthe net interest margin is representative of the change in the mix of earningassets towards lower yielding investments and to the lower rate environmentexperienced during 2002.  The rate oninterest earning assets decreased to 5.54% in 2002 from 7.61% in 2001 and ourcost on interest-bearing liabilities decreased to 3.27% in 2002 from 4.71% in2001.

 

Total earning assetsincreased by 70.5% to $450.3 million at December 31, 2002 as compared to $264.1million at December 31, 2001.  Thisincrease consisted mainly of $47.9 million, or 24.2% increase in net loans receivable,and a $129.5 million, or 379.3%, increase in investment securitiesavailable-for-sale.   These increaseswere primarily funded by total deposit growth of $177.5 million or 72.1% overDecember 31, 2001 balances.

 

Average investmentsecurities available-for-sale increased $94.6 million to $101.6 million during2002, funded primarily by the increase in average deposits of $150.7 millionduring 2002 compared to 2001.

 

Average total loansincreased $25.6 million to $206.7 million during 2002 from $181.0 million in2001.  Average balances fornonperforming 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.

 

Average total depositsincreased $150.7 million to $348.1 million in 2002 from $197.4 million in2001.  The largest increase in averagedeposit balances was experienced in interest checking, an increase of $96.7 millioncompared to 2001, as a result of our President’s Club relationship accountpromotion.

 

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Tables 2 and 3 containmore detailed information concerning average balances, yields earned, and ratespaid.

 

**Table 2.**

**AverageBalance Sheets and Interest Rates on Earning Assets and Interest - BearingLiabilities**As of and for the Years Ended December 31, 2002, 2001 and2000(Dollars in thousands)

 
|                                                    |   | **2002**             |    | **2001**                       |   | **2000** |   |
|---------------------------------------------------------|--------|----------------------|---------|--------------------------------|--------|----------|--------|
|                                                    |   | **Average  Balance** |    | **Interest  Income/  Expense** |   | **Rate** |   | **Average  Balance** |   | **Interest  Income/  Expense** |   | **Rate** |   | **Average  Balance** |   | **Interest  Income/  Expense** |   | **Rate** |   |
| **Assets**                                              |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                                  |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                              |   | $                    | 52,960  |                           | $      | 3,696    |   | 6.98 | % | $ | 52,063 |   | $ | 4,407 |   | 8.46 | % | $ | 35,605 |   | $ | 3,149 |   | 8.84 | % |
| Real estate - commercial                                |   | 91,289               |    | 7,276                          |   | 7.97     | %      | 72,500 |   | 6,288 |   | 8.67 | % | 33,546 |   | 2,899 |   | 8.64 | % |
| Real estate - construction                              |   | 6,156                |    | 375                            |   | 6.09     | %      | 5,634 |   | 487 |   | 8.64 | % | 2,425 |   | 287 |   | 11.84 | % |
| Real estate - residential                               |   | 20,139               |    | 1,534                          |   | 7.62     | %      | 17,972 |   | 1,501 |   | 8.35 | % | 15,568 |   | 1,447 |   | 9.29 | % |
| Home equity lines                                       |   | 23,711               |    | 993                            |   | 4.19     | %      | 18,023 |   | 1,146 |   | 6.36 | % | 7,307 |   | 698 |   | 9.55 | % |
| Consumer                                                |   | 12,399               |    | 924                            |   | 7.45     | %      | 14,827 |   | 1,144 |   | 7.72 | % | 9,518 |   | 778 |   | 8.17 | % |
| Total loans                                             |   | 206,654              |    | 14,798                         |   | 7.16     | %      | 181,019 |   | 14,973 |   | 8.27 | % | 103,969 |   | 9,258 |   | 8.90 | % |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment securities available-for-sale                |   | 101,589              |    | 4,501                          |   | 4.43     | %      | 7,022 |   | 437 |   | 6.22 | % | 6,068 |   | 371 |   | 6.11 | % |
| Other investments                                       |   | 1,253                |    | 72                             |   | 5.75     | %      | 1,373 |   | 82 |   | 5.97 | % | 1,036 |   | 70 |   | 6.76 | % |
| Federal funds sold                                      |   | 55,773               |    | 871                            |   | 1.56     | %      | 28,467 |   | 1,085 |   | 3.81 | % | 21,790 |   | 1,451 |   | 6.66 | % |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets and interest income       |   | 365,269              |    | 20,242                         |   | 5.54     | %      | 217,881 |   | 16,577 |   | 7.61 | % | 132,863 |   | 11,150 |   | 8.39 | % |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest earning assets:                            |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                 |   | 18,595               |    |                           |   |     |   | 10,467 |   |   |   |   |   | 5,890 |   |   |   |   |   |
| Premises and equipment, net                             |   | 4,820                |    |                           |   |     |   | 5,579 |   |   |   |   |   | 4,698 |   |   |   |   |   |
| Goodwill and other intangibles                          |   | 651                  |    |                           |   |     |   | 9,228 |   |   |   |   |   | 3,262 |   |   |   |   |   |
| Accrued interest and other assets                       |   | 2,551                |    |                           |   |     |   | 1,695 |   |   |   |   |   | 564 |   |   |   |   |   |
| Allowance for loan losses                               |   | (3,060               | )       |                           |   |     |   | (2,118 | ) |   |   |   |   | (1,184 | ) |   |   |   |   |
| Total assets                                            |   | $                    | 388,826 |                           |   |     |   |   | $ | 242,732 |   |   |   |   |   | $ | 146,093 |   |   |   |   |   |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and Shareholders’ Equity**           |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest - bearing liabilities:                         |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest - bearing deposits:                            |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest checking                                       |   | 114,350              |    | 3,073                          |   | 2.69     | %      | 17,675 |   | 370 |   | 2.09 | % | 5,375 |   | 130 |   | 2.42 | % |
| Money markets                                           |   | 28,667               |    | 525                            |   | 1.83     | %      | 25,346 |   | 767 |   | 3.03 | % | 15,256 |   | 624 |   | 4.09 | % |
| Statement savings                                       |   | 4,305                |    | 52                             |   | 1.21     | %      | 4,371 |   | 102 |   | 2.33 | % | 2,441 |   | 61 |   | 2.50 | % |
| Certificates of deposit                                 |   | 140,033              |    | 5,714                          |   | 4.08     | %      | 101,932 |   | 5,788 |   | 5.68 | % | 55,656 |   | 3,478 |   | 6.25 | % |
| Total interest - bearing deposits                       |   | 287,355              |    | 9,364                          |   | 3.26     | %      | 149,324 |   | 7,027 |   | 4.71 | % | 78,728 |   | 4,293 |   | 5.45 | % |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowed funds                                    |   | 5,564                |    | 222                            |   | 3.99     | %      | 10,002 |   | 473 |   | 4.73 | % | 6,904 |   | 447 |   | 6.47 | % |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities and interest expense |   | 292,919              |    | 9,586                          |   | 3.27     | %      | 159,326 |   | 7,500 |   | 4.71 | % | 85,632 |   | 4,740 |   | 5.54 | % |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                        |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                         |   | 60,786               |    |                           |   |     |   | 48,110 |   |   |   |   |   | 27,203 |   |   |   |   |   |
| Other liabilities                                       |   | 2,282                |    |                           |   |     |   | 2,790 |   |   |   |   |   | 2,043 |   |   |   |   |   |
| Preferred shareholders’ equity                     |   | 6,825                |    |                           |   |     |   | 7,056 |   |   |   |   |   | 2,371 |   |   |   |   |   |
| Common shareholders’ equity                        |   | 26,014               |    |                           |   |     |   | 25,450 |   |   |   |   |   | 28,844 |   |   |   |   |   |
| Total liabilities and shareholders’ equity         |   | $                    | 388,826 |                           |   |     |   |   | $ | 242,732 |   |   |   |   |   | $ | 146,093 |   |   |   |   |   |
|                                                    |   |                 |    |                           |   |     |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income and net interest margin             |   |                 |    | $                              | 10,656 |     | 2.92   | % |   |   | $ | 9,077 |   | 4.17 | % |   |   | $ | 6,410 |   | 4.82 | % |

 

27

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**Table 3.**

 

**Rate andVolume Analysis (Tax Equivalent Basis)**Years Ended December 31, 2002, 2001 and 2000(Dollars in thousands)

 
|                                      |   | **2002  Compared to 2001** |   | **2001  Compared to 2000** |   |
|-------------------------------------------|--------|----------------------------|--------|----------------------------|--------|
|                                      |   | **Average  Volume**        |   | **Average  Rate**          |   | **Increase  (Decrease)** |   | **Average  Volume** |   | **Average  Rate** |   | **Increase  (Decrease)** |   |
| **Interest  income:**                     |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Loans:                                    |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Commercial                                |   | $                          | 76     |                       | $      | (787 | ) | $ | (711 | ) | $ | 1,456 |   | $ | (198 | ) | $ | 1,258 |   |
| Real estate -  commercial                 |   | 1,630                      |   | (642                       | )      | 988 |   | 3,366 |   | 23 |   | 3,389 |   |
| Real estate -  construction               |   | 45                         |   | (157                       | )      | (112 | ) | 380 |   | (180 | ) | 200 |   |
| Real estate -  residential                |   | 181                        |   | (148                       | )      | 33 |   | 223 |   | (169 | ) | 54 |   |
| Home equity  lines                        |   | 362                        |   | (515                       | )      | (153 | ) | 1,024 |   | (576 | ) | 448 |   |
| Consumer                                  |   | (187                       | )      | (33                        | )      | (220 | ) | 434 |   | (68 | ) | 366 |   |
| Total loans                               |   | 2,107                      |   | (2,282                     | )      | (175 | ) | 6,883 |   | (1,168 | ) | 5,715 |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Investment  securities available-for-sale |   | 5,885                      |   | (1,821                     | )      | 4,064 |   | 58 |   | 8 |   | 66 |   |
| Other  investments                        |   | (7                         | )      | (3                         | )      | (10 | ) | 23 |   | (11 | ) | 12 |   |
| Federal funds  sold                       |   | 1,041                      |   | (1,255                     | )      | (214 | ) | 445 |   | (811 | ) | (366 | ) |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Total interest  income                    |   | 9,026                      |   | (5,361                     | )      | 3,665 |   | 7,408 |   | (1,982 | ) | 5,427 |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| **Interest  expense:**                    |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Interest -  bearing deposits:             |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Interest  checking                        |   | 2,024                      |   | 679                        |   | 2,703 |   | 297 |   | (57 | ) | 240 |   |
| Money markets                             |   | 100                        |   | (342                       | )      | (242 | ) | 413 |   | (270 | ) | 143 |   |
| Statement  savings                        |   | (2                         | )      | (48                        | )      | (49 | ) | 48 |   | (7 | ) | 41 |   |
| Certificates of  deposit                  |   | 2,163                      |   | (2,237                     | )      | (74 | ) | 2,893 |   | (583 | ) | 2,310 |   |
| Total interest -  bearing deposits        |   | 4,285                      |   | (1,947                     | )      | 2,337 |   | 3,651 |   | (917 | ) | 2,734 |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Other borrowed  funds                     |   | (210                       | )      | (41                        | )      | (251 | ) | 201 |   | (175 | ) | 26 |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Total interest  expense                   |   | 4,075                      |   | (1,988                     | )      | 2,086 |   | 3,852 |   | (1,092 | ) | 2,760 |   |
|                                      |   |                       |   |                       |   |   |   |   |   |   |   |   |   |
| Net interest  income                      |   | $                          | 4,951  |                       | $      | (3,372 | ) | $ | 1,578 |   | $ | 3,557 |   | $ | (890 | ) | $ | 2,667 |   |

 

28

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*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 allowance forloan 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 losses was $444,000 in 2002 as compared to $1.2million in 2001 due primarily to the strong loan quality experienced and achange in our portfolio mix with increases in our residential and home equityloan portfolios, which require lower reserve amounts than the remainder of theloan portfolio.

 

The allowance for loanlosses increased to $3.4 million in 2002 from $3.1 million in 2001.  The ratio of the allowance for loan lossesto total loans, net of fees, at December 31, 2002 was 1.35% compared to 1.54%at December 31, 2001.  We experiencedloan charge offs of $117,000 for the year ended December 31, 2002 offset byrecoveries of $15,000.  We had no chargeoffs prior to 2002.

 

Tables 4 and 5 containadditional information pertaining to the calculation and allocation of theallowance for loan losses.

 

 

**Table 4.**

**Allowancefor Loan Losses**As of December 31, 2002, 2001, 2000, 1999 and 1998(Dollars in thousands)

 
|                                                       |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Beginning  balance, January 1                              |   | $        | 3,104  |     | $      | 1,900    |   | $        | 726    |     | $      | 212 |   | $ | — |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Provision for  loan losses                                 |   | 444      |   | 1,202    |   | 753      |   | 514      |   | 212      |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Transfer to  bank’s liability on unfunded commitments |   | (74      | )      | —   |   | —   |   | —   |   | —   |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Assumed  allowance for loan losses                         |   |     |   |     |   |     |   |     |   |     |   |
| from acquisition  of Heritage Bancorp, Inc.                |   | —   |   | —   |   | 421      |   | —   |   | —   |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Loans charged  off:                                        |   |     |   |     |   |     |   |     |   |     |   |
| Commercial                                                 |   | (63      | )      | —   |   | —   |   | —   |   | —   |   |
| Real estate -  commercial                                  |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate -  construction                                |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate -  residential                                 |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Home equity lines                                          |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Consumer                                                   |   | (54      | )      | —   |   | —   |   | —   |   | —   |   |
| Total loans  charged off                                   |   | (117     | )      | —   |   | —   |   | —   |   | —   |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Recoveries:                                                |   |     |   |     |   |     |   |     |   |     |   |
| Commercial                                                 |   | 12       |   | 2        |   | —   |   | —   |   | —   |   |
| Real estate -  commercial                                  |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate -  construction                                |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Real estate -  residential                                 |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Home equity  lines                                         |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Consumer                                                   |   | 3        |   | —   |   | —   |   | —   |   | —   |   |
| Total recoveries                                           |   | 15       |   | 2        |   | —   |   | —   |   | —   |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Net (charge  offs) recoveries                              |   | (102     | )      | 2        |   | —   |   | —   |   | —   |   |
|                                                       |   |     |   |     |   |     |   |     |   |     |   |
| Ending balance,  December 31,                              |   | $        | 3,372  |     | $      | 3,104    |   | $        | 1,900  |     | $      | 726 |   | $ | 212 |   |

 
| **Loans:**                                   |   | **2002** |    | **2001** |   | **2000** |   | **1999** |    | **1998** |   |
|----------------------------------------------|--------|----------|---------|----------|--------|----------|--------|----------|---------|----------|--------|
| Balance at year  end                         |   | $        | 249,106 |     | $      | 200,911  |   | $        | 154,271 |     | $      | 68,167 |   | $ | 16,327 |   |
| Allowance for  loan losses to year end loans |   | 1.35     | %       | 1.54     | %      | 1.23     | %      | 1.07     | %       | 1.30     | %      |
|                                              |        |          |         |          |        |          |        |          |         |          |        |  |  |  |  |  |

 

29

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Table 5 shows theallocation of the allowance for loan losses by loan type and the percentage ofthe loan type to the total loan portfolio.

 

 

**Table 5.**

 

**Allocationof the Allowance for Loan Losses**As of December 31, 2002, 2001, 2000, 1999 and 1998(Dollars in thousands)

 
|                             |   | **2002**       |   | **2001**        |   | **2000**       |   |
|----------------------------------|--------|----------------|--------|-----------------|--------|----------------|--------|
|                             |   | **Allocation** |   | **% of Total*** |   | **Allocation** |   | **% of Total*** |   | **Allocation** |   | **% of Total*** |   |
| Commercial                       |   | $              | 1,301  |            | 23.40  | %              | $      | 1,149 |   | 28.71 | % | $ | 612 |   | 32.22 | % |
| Real estate -  commercial        |   | 1,386          |   | 46.63           | %      | 1,270          |   | 43.37 | % | 704 |   | 37.05 | % |
| Real estate -  construction      |   | 19             |   | 2.32            | %      | 34             |   | 3.18 | % | 50 |   | 2.65 | % |
| Real estate -  residential       |   | 241            |   | 12.77           | %      | 98             |   | 7.20 | % | 219 |   | 11.51 | % |
| Home equity  lines               |   | 201            |   | 10.77           | %      | 176            |   | 10.60 | % | 183 |   | 9.65 | % |
| Consumer                         |   | 224            |   | 4.11            | %      | 377            |   | 6.94 | % | 253 |   | 6.92 | % |
|                             |   |           |   |            |   |           |   |   |   |   |   |   |   |
| Total allowance  for loan losses |   | $              | 3,372  |            | 100.00 | %              | $      | 3,104 |   | 100.00 | % | $ | 2,022 |   | 100.00 | % |
|                             |   |           |   |            |   |           |   |   |   |   |   |   |   |

 
|                             |   | **1999**       |   | **1998**        |   |
|----------------------------------|--------|----------------|--------|-----------------|--------|
|                             |   | **Allocation** |   | **% of Total*** |   | **Allocation** |   | **% of Total*** |   |
| Commercial                       |   | $              | 241    |            | 33.10  | % | $ | 59 |   | 31.44 | % |
| Real estate -  commercial        |   | 211            |   | 29.03           | %      | 40 |   | 21.46 | % |
| Real estate -  construction      |   | 9              |   | 1.28            | %      | 9 |   | 4.65 | % |
| Real estate -  residential       |   | 126            |   | 17.39           | %      | 64 |   | 33.83 | % |
| Home equity  lines               |   | 40             |   | 5.54            | %      | 12 |   | 6.36 | % |
| Consumer                         |   | 99             |   | 13.66           | %      | 28 |   | 2.26 | % |
|                             |   |           |   |            |   |   |   |   |   |
| Total allowance  for loan losses |   | $              | 726    |            | 100.00 | % | $ | 212 |   | 100.00 | % |

 

----

* Percentage of loan type to the total loan portfolio.

 

30

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*Non-Interest Income*

 

Non-interest incomecontinues to be an important factor in our operating results.  Non-interest income was $3.3 million forboth years ended December 31, 2002 and 2001. Investment fee income from oursubsidiary, Cardinal Wealth Services, Inc., decreased by $1.0 million to$940,000 for the year ended December 31, 2002 compared to $1.9 million in2001.  This decrease was a result of thedecreased market activity and assets under management experienced during2002.  Due to our increased number ofdeposit accounts, service charges on deposit accounts increased $113,000 to$511,000 during 2002 as compared to $398,000 in 2001.  We had net realized gains on sales of investment securitiesavailable-for-sale of $524,000 for the year ended December 31, 2002 compared tonone during 2001.  During 2002 and 2001,we consolidated operations, sublet excess space and received rental income of$409,000, an increase of $299,000, or 271.8%, from 2001.  Table 6 provides additional detail onnon-interest income for the years ended December 31, 2002, 2001, and 2000.

 

 

**Table 6.**

**Non-InterestIncome**Years Ended December 31, 2002, 2001 and 2000(Dollars in thousands)

 
|                                                                  |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Service charges  on deposit accounts                                  |   | $        | 511    |     | $      | 398      |   | $ | 154 |   |
| Loan service  charges                                                 |   | 392      |   | 433      |   | 230      |   |
| Investment fee  income                                                |   | 940      |   | 1,941    |   | 1,516    |   |
| Net gain (loss)  on sales of loans                                    |   | 74       |   | 49       |   | (23      | )      |
| Net realized  gain (loss) on investment securities available-for-sale |   | 524      |   | —   |   | (32      | )      |
| Net gain on  sales of assets                                          |   | 39       |   | 18       |   | 57       |   |
| Rent income                                                           |   | 409      |   | 110      |   | —   |   |
| ATM transaction  fees                                                 |   | 100      |   | 92       |   | 26       |   |
| Credit card fees                                                      |   | 46       |   | 39       |   | 29       |   |
| Check order fees                                                      |   | 101      |   | 62       |   | 34       |   |
| Other income                                                          |   | 137      |   | 125      |   | 107      |   |
| **Total  non-interest income**                                        |   | $        | 3,273  |     | $      | 3,267    |   | $ | 2,098 |   |

 

31

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*Non-Interest Expense*

 

Non-interest expense was$14.0 million and $23.9 million for the years ended December 31, 2002 and 2001,respectively.  The decrease innon-interest expense of $9.9 million, or 41.3% for 2002 compared to 2001 resultedmostly from a one-time 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 restructure from four banks to one to simplifyour structure and reduce costs. Consequently, included in non-interest expensefor 2001 is approximately $884,000 in non-recurring costs associated with therestructuring.

 

During the second quarterof 2002, we recorded an impairment on an investment in a WorldCom bond of $1.7million.  Excluding the effect of theone-time charge related to the Heritage Bancorp goodwill in 2001 and the $1.7million impairment writedown of the WorldCom bond in 2002, total non-interestexpense declined $3.2 million in 2002 compared to 2001.  This substantial decline in non-interestexpense was due primarily to decreases in salaries and benefits expense, aswell as discontinuation of goodwill amortization in 2002 due to theimplementation 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.  Table 7 reflects the components ofnon-interest expense for the years ended December 31, 2002, 2001 and 2000.

 

 

**Table 7.**

**Non-InterestExpense**Years Ended December 31, 2002, 2001 and 2000(Dollars in thousands)

 
|                                        |   | **2002** |   | **2001** |   | **2000** |   |
|---------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Salary and  benefits                        |   | $        | 5,715  |     | $      | 7,731    |   | $ | 6,317 |   |
| Occupancy                                   |   | 1,381    |   | 1,373    |   | 1,075    |   |
| Professional  fees                          |   | 1,011    |   | 705      |   | 508      |   |
| Depreciation                                |   | 736      |   | 804      |   | 601      |   |
| Amortization and  write down of intangibles |   | 22       |   | 8,907    |   | 235      |   |
| Writedown of  WorldCom bond                 |   | 1,660    |   | —   |   | —   |   |
| Data processing                             |   | 759      |   | 957      |   | 561      |   |
| Stationary and  supplies                    |   | 317      |   | 306      |   | 345      |   |
| Brokerage  clearing                         |   | 206      |   | 370      |   | 345      |   |
| Advertising and  marketing                  |   | 541      |   | 368      |   | 241      |   |
| Telecommunications                          |   | 276      |   | 325      |   | 254      |   |
| Other taxes                                 |   | 342      |   | 269      |   | 221      |   |
| Travel and  entertainment                   |   | 127      |   | 164      |   | 139      |   |
| Bank operations                             |   | 411      |   | 875      |   | 165      |   |
| Premises and  equipment                     |   | 271      |   | 247      |   | 142      |   |
| Miscellaneous                               |   | 239      |   | 465      |   | 577      |   |
| Total  non-interest expense                 |   | $        | 14,014 |     | $      | 23,866   |   | $ | 11,726 |   |

 

32

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*Income Taxes*

 

We have not recordedincome tax expense or benefit due to the availability of net losses in 2002 andall prior years of operations.  Theability to utilize net operating loss carryforwards will be dependent on ourability to generate future taxable earnings. Footnote 9 to the Notes to Consolidated Financial Statements providesadditional information with respect to the deferred tax accounts and the netoperating loss carryforward.

 

**Statements of Condition**

 

*Loans Receivable*

 

We have comprehensivepolicies and procedures that cover both commercial and consumer loanorigination and management of credit risk. Loans are underwritten in a manner that focuses on the borrower’sability to repay.  Our goal is not toavoid risk, but to manage it and to include credit risk as part of the pricingdecision for each product.

 

Total loans, net of feesand premiums and discounts, increased $48.2 million to $249.1 million atDecember 31, 2002.  The strongest growthwas in commercial real estate loans and residential real estate loans.

 

Our loan portfolio has aheavy commercial orientation as evidenced by the information provided in Table8.  We began in late 1999 to betterdiversify the loan portfolio by purchasing consumer loans.  We continued to diversify our portfolio in2002 and 2001 by establishing a separate retail lending group, creating competitivehome equity products, and by purchasing small pools of residential mortgages.

 

 

**Table 8.**

**LoansReceivable**As of December 31, 2002, 2001, 2000, 1999 and 1998(Dollars in thousands)

 
|                             |   | **2002** |    | **2001** |   | **2000** |   |
|----------------------------------|--------|----------|---------|----------|--------|----------|--------|
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Commercial                       |   | $        | 58,292  |     | 23.40  | %        | $      | 57,665 |   | 28.71 | % | $ | 49,646 |   | 32.22 | % |
| Real estate -  commercial        |   | 116,135  |    | 46.63    | %      | 87,116   |   | 43.37 | % | 57,083 |   | 37.05 | % |
| Real estate -  construction      |   | 5,781    |    | 2.32     | %      | 6,397    |   | 3.18 | % | 4,088 |   | 2.65 | % |
| Real estate -  residential       |   | 31,808   |    | 12.77    | %      | 14,469   |   | 7.20 | % | 17,729 |   | 11.51 | % |
| Home equity  lines               |   | 26,831   |    | 10.77    | %      | 21,299   |   | 10.60 | % | 14,867 |   | 9.65 | % |
| Consumer                         |   | 10,235   |    | 4.11     | %      | 13,941   |   | 6.94 | % | 10,665 |   | 6.92 | % |
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Gross loans                      |   | $        | 249,082 |     | 100.00 | %        | $      | 200,887 |   | 100.00 | % | $ | 154,078 |   | 100.00 | % |
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Add: unearned  income, net       |   | 24       |    |     |   | 24       |   |   |   | 193 |   |   |   |
| Less: allowance  for loan losses |   | (3,372   | )       |     |   | (3,104   | )      |   |   | (1,900 | ) |   |   |
|                             |   |     |    |     |   |     |   |   |   |   |   |   |   |
| Loans  receivable, net           |   | $        | 245,734 |     |   |     | $      | 197,807 |   |   |   | $ | 152,371 |   |   |   |

 
|                             |   | **1999** |   | **1998** |   |
|----------------------------------|--------|----------|--------|----------|--------|
|                             |   |     |   |     |   |   |   |   |   |
| Commercial                       |   | $        | 22,558 |     | 33.10  | % | $ | 5,138 |   | 31.44 | % |
| Real estate -  commercial        |   | 19,780   |   | 29.03    | %      | 3,507 |   | 21.46 | % |
| Real estate -  construction      |   | 870      |   | 1.28     | %      | 760 |   | 4.65 | % |
| Real estate -  residential       |   | 11,851   |   | 17.39    | %      | 5,529 |   | 33.83 | % |
| Home equity  lines               |   | 3,777    |   | 5.54     | %      | 1,040 |   | 6.36 | % |
| Consumer                         |   | 9,311    |   | 13.66    | %      | 369 |   | 2.26 | % |
|                             |   |     |   |     |   |   |   |   |   |
| Gross loans                      |   | $        | 68,147 |     | 100.00 | % | $ | 16,343 |   | 100.00 | % |
|                             |   |     |   |     |   |   |   |   |   |
| Add: unearned  income, net       |   | 20       |   |     |   | (16 | ) |   |   |
| Less: allowance  for loan losses |   | (726     | )      |     |   | (212 | ) |   |   |
|                             |   |     |   |     |   |   |   |   |   |
| Loans  receivable, net           |   | $        | 67,441 |     |   |   | $ | 16,115 |   |   |   |

 

33

----

 

Loans receivableaccounted for 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 toprincipal or interest payments as of December 31, 2002 and 2001, were $59,000and $566,000, respectively.  There areno loans as of December 31, 2002 and 2001 included above which are “troubleddebt restructurings” as defined in SFAS No. 15, “Accounting by Debtors andCreditors for Troubled Debt Restructurings*.*” Table 9 shows nonperforming loans at the end of each of the past fiveyears.  Gross interest income that wouldhave been recorded if the nonaccrual loans had been current with their originalterms and had been outstanding throughout the period or since origination ifheld for part of the period for 2002 was $37,000.  The interest income realized prior to the loans being placed onnonaccrual status for 2002 was $28,000.

 

Specific reserves of$28,000 were recorded in 2002 for one of the non-accrual loans.  Interest income on non-accrual loans, ifrecognized, is recorded using the cash basis method of accounting.  When a loan is placed on non-accrual, unpaidinterest is reversed against interest income if it was accrued in the currentyear and is charged to the allowance for loan losses if it was accrued in prioryears.  While on non-accrual, thecollection of interest is recorded as interest income only after all principalhas been collected.  When all pastcontractual obligations are collected and, in our opinion, the borrower hasdemonstrated the ability to remain current, the loan is returned to an accruingstatus.    At December 31, 2002 theratio of non-performing loans to total loans was 0.37% as compared to 0.18% atDecember 31, 2001.

 

 

**Table 9.**

**NonperformingLoans Receivable**

As of December 31,2002, 2001, 2000, 1999, and 1998

(Dollars inthousands)

 
|                                  |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|---------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Nonaccruing  loans                    |   | $        | 917    |     | $      | 361      |   | $        | 585    |     | $      | — |   | $ | — |   |
|                                  |   |     |   |     |   |     |   |     |   |     |   |
| Loans  contractually past-due         |   |     |   |     |   |     |   |     |   |     |   |
| 90  days or more                      |   | 59       |   | 566      |   | 2        |   | —   |   | —   |   |
|                                  |   |     |   |     |   |     |   |     |   |     |   |
| Troubled  debt restructurings         |   | —   |   | —   |   | —   |   | —   |   | —   |   |
| Total  nonperforming loans receivable |   | $        | 976    |     | $      | 927      |   | $        | 587    |     | $      | — |   | $ | — |   |

 

34

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*Investment Securities Available-for-Sale*

 

Our investment securitiesportfolio is used as a source of income and liquidity.  Investment securities available-for-saleincreased to $163.7 million at December 31, 2002 as compared to $34.1 millionat December 31, 2001.  Strong depositgrowth during 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. Table 10 reflects the composition of the investment portfolio as ofDecember 31, 2002, 2001 and 2000.

 

 

**Table10.**

**InvestmentSecurities Available-for-Sale**

As of December 31,2002, 2001 and 2000

(Dollars inthousands)

 
| **As of  December 31, 2002**                    |   | **Par Value** |    | **Amortized  Cost** |   | **Fair  Value** |   | **Unrealized  Gain/(Loss)** |    | **Average  Yield** |   |
|-------------------------------------------------|--------|---------------|---------|---------------------|--------|-----------------|--------|-----------------------------|---------|--------------------|--------|
| U.S. government agencies  and enterprises       |   |          |    |                |   |            |   |                        |    |               |   |
| One  to five years                              |   | $             | 26,750  |                | $      | 26,739          |   | $                           | 26,988  |               | $      | 249 |   | 3.47 | % |
| Five  to ten years                              |   | 12,000        |    | 12,048              |   | 12,048          |   | —                      |    | 3.68               | %      |
| Total  U.S. government agencies                 |   | $             | 38,750  |                | $      | 38,787          |   | $                           | 39,036  |               | $      | 249 |   | 3.53 | % |
|                                            |   |          |    |                |   |            |   |                        |    |               |   |
| Mortgage-backed  securities                     |   |          |    |                |   |            |   |                        |    |               |   |
| Within  one year                                |   | $             | 15,325  |                | $      | 15,478          |   | $                           | 15,750  |               | $      | 272 |   | 3.61 | % |
| One  to five years                              |   | 69,265        |    | 70,552              |   | 72,342          |   | 1,790                       |    | 4.82               | %      |
| Five  to ten years                              |   | 13,385        |    | 13,695              |   | 13,686          |   | (9                          | )       | 4.43               | %      |
| After  ten years                                |   | 13,940        |    | 15,301              |   | 15,301          |   | —                      |    | 5.20               | %      |
| Total  mortgage-backed securities               |   | $             | 111,915 |                | $      | 115,026         |   | $                           | 117,079 |               | $      | 2,053 |   | 4.65 | % |
|                                            |   |          |    |                |   |            |   |                        |    |               |   |
| Other  bonds                                    |   |          |    |                |   |            |   |                        |    |               |   |
| After  ten years                                |   | 5,000         |    | 5,000               |   | 5,000           |   | —                      |    | 3.39               | %      |
| Total  other bonds                              |   | $             | 5,000   |                | $      | 5,000           |   | $                           | 5,000   |               | $      | — |   | 3.39 | % |
|                                            |   |          |    |                |   |            |   |                        |    |               |   |
| Treasury  bonds                                 |   |          |    |                |   |            |   |                        |    |               |   |
| One  to five years                              |   | $             | 2,500   |                | $      | 2,507           |   | $                           | 2,550   |               | $      | 43 |   | 2.67 | % |
| Total  treasury bonds                           |   | $             | 2,500   |                | $      | 2,507           |   | $                           | 2,550   |               | $      | 43 |   | 2.67 | % |
|                                            |   |          |    |                |   |            |   |                        |    |               |   |
| Total  investment securities available-for-sale |   | $             | 158,165 |                | $      | 161,320         |   | $                           | 163,665 |               | $      | 2,345 |   | 4.32 | % |

 
| **As of  December 31, 2001**                    |   | **Par Value** |   | **Amortized  Cost** |   | **Fair  Value** |   | **Unrealized  Gain/(Loss)** |   | **Average  Yield** |   |
|-------------------------------------------------|--------|---------------|--------|---------------------|--------|-----------------|--------|-----------------------------|--------|--------------------|--------|
| U.S.  government agencies and enterprises       |   |          |   |                |   |            |   |                        |   |               |   |
| One  to five years                              |   | $             | 3,000  |                | $      | 2,985           |   | $                           | 2,950  |               | $      | (35 | ) | 4.15 | % |
| Five  to ten years                              |   | 1,500         |   | 1,516               |   | 1,508           |   | (8                          | )      | 4.67               | %      |
| Total  U.S. government agencies                 |   | $             | 4,500  |                | $      | 4,501           |   | $                           | 4,458  |               | $      | (43 | ) | 4.32 | % |
|                                            |   |          |   |                |   |            |   |                        |   |               |   |
| Mortgage-backed  securities                     |   |          |   |                |   |            |   |                        |   |               |   |
| Within  one year                                |   | $             | 182    |                | $      | 182             |   | $                           | 183    |               | $      | 1 |   | 2.55 | % |
| One  to five years                              |   | 11,210        |   | 11,456              |   | 11,383          |   | (73                         | )      | 5.22               | %      |
| Five  to ten years                              |   | 5,804         |   | 5,927               |   | 5,865           |   | (62                         | )      | 5.79               | %      |
| After  ten years                                |   | 4,849         |   | 4,965               |   | 4,926           |   | (39                         | )      | 5.96               | %      |
| Total  mortgage-backed securities               |   | $             | 22,045 |                | $      | 22,530          |   | $                           | 22,357 |               | $      | (173 | ) | 5.51 | % |
|                                            |   |          |   |                |   |            |   |                        |   |               |   |
| Corporate  bonds                                |   |          |   |                |   |            |   |                        |   |               |   |
| One  to five years                              |   | $             | 6,000  |                | $      | 6,154           |   | $                           | 6,114  |               | $      | (40 | ) | 5.42 | % |
| Five  to ten years                              |   | 1,000         |   | 986                 |   | 969             |   | (17                         | )      | 6.98               | %      |
| Total  corporate bonds                          |   | $             | 7,000  |                | $      | 7,140           |   | $                           | 7,083  |               | $      | (57 | ) | 5.64 | % |
|                                            |   |          |   |                |   |            |   |                        |   |               |   |
| Treasury  bonds                                 |   |          |   |                |   |            |   |                        |   |               |   |
| Within  one year                                |   | $             | 250    |                | $      | 250             |   | $                           | 249    |               | $      | (1 | ) | 1.87 | % |
| Total  treasury bonds                           |   | $             | 250    |                | $      | 250             |   | $                           | 249    |               | $      | (1 | ) | 1.87 | % |
|                                            |   |          |   |                |   |            |   |                        |   |               |   |
| Total  investment securities available-for-sale |   | $             | 33,795 |                | $      | 34,421          |   | $                           | 34,147 |               | $      | (274 | ) | 5.36 | % |

 
| **As of  December 31, 2000**               |   | **Par Value** |   | **Amortized  Cost** |   | **Fair  Value** |   | **Unrealized  Gain/(Loss)** |   | **Average  Yield** |   |
|-------------------------------------------------|--------|---------------|--------|---------------------|--------|-----------------|--------|-----------------------------|--------|--------------------|--------|
| U.S.  government agencies and enterprises       |   |          |   |                |   |            |   |                        |   |               |   |
| Within  one year                                |   | $             | 500    |                | $      | 500             |   | $                           | 497    |               | $      | (3 | ) | 5.25 | % |
| One  to five years                              |   | 4,000         |   | 3,949               |   | 3,999           |   | 50                          |   | 6.85               | %      |
| After  ten years                                |   | 1,377         |   | 1,403               |   | 1,374           |   | (29                         | )      | 6.64               | %      |
| Total  U.S. government agencies                 |   | $             | 5,877  |                | $      | 5,852           |   | $                           | 5,870  |               | $      | 18 |   | 6.66 | % |
|                                            |   |          |   |                |   |            |   |                        |   |               |   |
| Mortgage-backed  securities                     |   |          |   |                |   |            |   |                        |   |               |   |
| Within  one year                                |   | $             | 30     |                | $      | 30              |   | $                           | 30     |               | $      | — |   | 5.50 | % |
| One  to five years                              |   | 740           |   | 742                 |   | 734             |   | (8                          | )      | 6.44               | %      |
| Five  to ten years                              |   | 306           |   | 307                 |   | 301             |   | (6                          | )      | 5.92               | %      |
| Total  mortgage-backed securities               |   | $             | 1,076  |                | $      | 1,079           |   | $                           | 1,065  |               | $      | (14 | ) | 6.27 | % |
|                                            |   |          |   |                |   |            |   |                        |   |               |   |
| Total  investment securities available-for-sale |   | $             | 6,953  |                | $      | 6,931           |   | $                           | 6,935  |               | $      | 4 |   | 6.60 | % |

 

35

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*Interest Rate Sensitivity*

 

Our Asset/LiabilityCommittee is responsible for reviewing the Company’s 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.  The difference is the interest sensitivitygap, which indicates how future changes in interest rates may affect netinterest income.  Interest sensitivitygap analysis presents a position that existed at one particular point in timeand assumes that assets and liabilities with similar characteristics willre-price at the same time and to the same degree.  Regardless of whether interest rates are expected to increase ordecrease, the objective is to maintain a gap position that will minimize anychanges in net interest income.  Anegative gap exists when we have more interest sensitive liabilities maturingwithin a certain gap interval than interest sensitive assets.  Under this scenario, if interest rates wereto increase, it would tend to reduce interest income.

 

At December 31, 2002, wewere liability sensitive in the 2-90 day, 91-180 day and 181-365 day gapintervals by 1.6%, 5.1% and 7.0%, respectively.  This is within the Company’s asset/liability management policy,which indicates that we maintain an interest rate sensitivity position +/-15%to total assets.  We can reprice ourinterest checking, savings, and money market accounts at any time.  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 through the 1-3 year gapinterval, leaving the remaining portion or 40% of these deposits in the over 3year gap interval.

 

We utilize a simulationmodeling process to measure interest rate risk and the impact that ratefluctuations will have on net interest income. These simulations incorporate assumptions regarding balance sheet growthand mix, and the re-pricing and maturity characteristics of existing andprojected balance sheets.  One of theways we manage our interest rate risk is through an analysis of therelationship between interest-earnings assets and interest-bearing liabilitiesto measure the impact that future changes in interest rates will have on netinterest income.  Using this analysis,changes in interest rates and volumes are used to test the sensitivity of ournet interest income.  Simulationanalysis uses a more dynamic version of the information shown in Tables 11 and12, which reflects re-pricing or expected maturities of various assets andliabilities at December 31, 2002.  Whilewe show liability sensitivity in the short term indicating that an increase ininterest rates may negatively affect short-term net interest income, we would likelytake actions to minimize our exposure to negative results and within a shortperiod of time make adjustments so that net interest income would not bematerially impacted.

 

During 2002, our focuswas to increase our deposit market share through promotion of our President’sClub and Totally Free Checking products. The success of these promotions allowed us to grow total assets over74.0%.  Our President’s Clubrelationship product allows customers with aggregate balances of over $10,000to earn an above market rate on their average balances, 2.00% as of December31, 2002.  Because of the success ofthis promotion, deposits grew more quickly than we could invest in higheryielding assets.  As a result, our netinterest margin declined throughout the year and averaged 2.92% for all of2002.  Our current focus is to improveour net interest margin by staying fully invested, minimizing lower yieldingshort-term investments and using our substantial mortgage-backed investmentsecurities portfolio for backup liquidity needs.

 

Over time, net interestincome will tend to be greater at higher interest rate levels.  This is due to the large proportion oflow-cost core deposits such as demand, interest checking, savings, and moneymarket accounts comprising our funding sources, which can be invested inrelatively higher yielding loans and investment securities.

 

**Table11.**

 

**InterestRate Sensitivity Gap Analysis**

As of December 31,2002

(Dollars inthousands)

 
|                                                              |                                  | **Immediate  Repricing** |       | **2-90  Days** |       | **91-180  Days** |       | **181-365  Days** |       | **1-3  Years** |       | **Over 3  Years** |       | **TOTAL** |       |
|-------------------------------------------------------------------|---------------------------------------|--------------------------|------------|----------------|------------|------------------|------------|-------------------|------------|----------------|------------|-------------------|------------|-----------|------------|
| **Assets**                                                        |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| Investment securities available-for-sale & other investments  |                                  | **$**                    | **—** |           | $          | 2,163            |       | $                 | 5,138      |           | $          | 8,450             |       | $         | 78,148     |   | $ | 71,381 |   | $ | 165,280 |   |
| Federal funds sold                                                |                                  | 35,906                   |       | —         |       | —           |       | —            |       | —         |       | —            |       | 35,906    |       |
| **Loans Receivable**                                              |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| Commercial & industrial                                       |                                  | 41,005                   |       | 5,420          |       | 3,467            |       | 8,767             |       | 47,538         |       | 68,230            |       | 174,427   |       |
| Residential                                                       |                                  | 109                      |       | 169            |       | 814              |       | 1,633             |       | 7,530          |       | 21,553            |       | 31,808    |       |
| Home equity lines                                                 |                                  | 7,737                    |       | 18,465         |       | 313              |       | 316               |       | —         |       | —            |       | 26,831    |       |
| Construction                                                      |                                  | 4,301                    |       | 14             |       | 6                |       | 13                |       | 84             |       | 1,363             |       | 5,781     |       |
| All other                                                         |                                  | 1,044                    |       | 623            |       | 373              |       | 742               |       | 2,206          |       | 5,247             |       | 10,235    |       |
| **Total loans receivable**                                        |                                  | 54,196                   |       | 24,691         |       | 4,973            |       | 11,471            |       | 57,358         |       | 96,393            |       | 249,082   |       |
| **Total earning assets**                                          |                                  | 90,102                   |       | 26,854         |       | 10,111           |       | 19,921            |       | 135,506        |       | 167,774           |       | 450,268   |       |
| **Cumulative rate sensitive assets**                              |                                  | $                        | 90,102     |           | $          | 116,956          |       | $                 | 127,067    |           | $          | 146,988           |       | $         | 282,494    |   | $ | 450,268 |   |   |   |
|                                                              |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| **Liabilities**                                                   |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| **Deposits**                                                      |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| Noninterest-bearing demand                                        |                                  | $                        | —     |           | $          | —           |       | $                 | —     |           | $          | —            |       | $         | —     |   | $ | 72,962 |   | $ | 72,962 |   |
| Interest-bearing transaction accounts                             |                                  | 35,384                   |       | 17,692         |       | 17,692           |       | 17,692            |       | 17,692         |       | 70,967            |       | 177,119   |       |
| Certificates of deposit - fixed                                   |                                  | —                   |       | 5,176          |       | 10,263           |       | 20,011            |       | 53,477         |       | 17,741            |       | 106,668   |       |
| Certificates of deposit - no penalty                              |                                  | —                   |       | 11,727         |       | 6,071            |       | 15,150            |       | 33,782         |       | —            |       | 66,730    |       |
| **Total deposits**                                                |                                  | 35,384                   |       | 34,595         |       | 34,026           |       | 52,853            |       | 104,951        |       | 161,670           |       | 423,479   |       |
| **Other borrowed funds**                                          |                                  | —                   |       | —         |       | 1,000            |       | 1,000             |       | —         |       | —            |       | 2,000     |       |
| **Total deposits & other borrowed funds**                     |                                  | 35,384                   |       | 34,595         |       | 35,026           |       | 53,853            |       | 104,951        |       | 161,670           |       | 425,479   |       |
| **Cumulative rate sensitive liabilities**                         |                                  | $                        | 35,384     |           | $          | 69,979           |       | $                 | 105,005    |           | $          | 158,858           |       | $         | 263,809    |   | $ | 425,479 |   |   |   |
|                                                              |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| **Gap**                                                           |                                  | $                        | 54,718     |           | $          | (7,741           | )          | $                 | (24,915    | )              | $          | (33,932           | )          | $         | 30,555     |   | $ | 6,104 |   |   |   |
| **Cumulative gap**                                                |                                  | 54,718                   |       | 46,977         |       | 22,062           |       | (11,870           | )          | 18,685         |       | 24,789            |       |      |       |
| **Gap/ total assets**                                             |                                  | 11.25                    | %          | -1.59          | %          | -5.12            | %          | -6.98             | %          | 6.28           | %          | 1.26              | %          |      |       |
| **Cumulative gap/ total assets**                                  |                                  | 11.25                    | %          | 9.66           | %          | 4.54             | %          | -2.44             | %          | 3.84           | %          | 5.10              | %          |      |       |
| **Rate sensitive assets/ rate sensitive liabilities**             |                                  | 2.55x                    |       | 0.78x          |       | 0.29x            |       | 0.37x             |       | 1.29x          |       | 1.04x             | ** ** |      | ** ** |
| **Cumulative rate sensitive assets/ rate sensitive  liabilities** |                                  | 2.55x                    |       | 1.67x          |       | 1.21x            |       | 0.93x             |       | 1.07x          |       | 1.06x             | ** ** |      | ** ** |
|                                                              |                                  |                     | ** ** |           | ** ** |             | ** ** |              | ** ** |           | ** ** |              | ** ** |      | ** ** |
| **Rate shock at +2.00%**                                          |                                  | $                        | 1,091      |           | $          | (154             | )          | $                 | (497       | )              | $          | (677              | )          |      | ** ** |   | ** ** |   | ** ** |
| **Net interest income at risk by period**                         |                                  | 10.24                    | %          | -1.45          | %          | -4.66            | %          | -6.35             | %          |           |       |              |       |      |       |
| **Annualized net interest income**                                |                                  | $                        | 10,656     |           |       |             |       |              |       |           |       |              |       |      |       |   |
| **Net interest income at risk for one year period**               |                                  | -2.22                    | %          |           |       |             |       |              |       |           |       |              |       |      |       |
| **$**                                                             | ** net interest income at risk** |                     | $          | (237           | )          |             |       |              |       |           |       |              |       |      |       |   |   |
|                                                              |                                  |                     |       |           |       |             |       |              |       |           |       |              |       |      |       |
| **Rate shock at -2.00%**                                          |                                  | $                        | (1,091     | )              | $          | 154              |       | $                 | 497        |           | $          | 677               |       |      |       |   |   |   |   |
| **Net interest income at risk by period**                         |                                  | -10.24                   | %          | 1.45           | %          | 4.66             | %          | 6.35              | %          |           |       |              |       |      |       |
| **Annualized net interest income**                                |                                  | $                        | 10,656     |           |       |             |       |              |       |           |       |              |       |      |       |   |
| **Net interest income at risk for one year period**               |                                  | 2.22                     | %          |           |       |             |       |              |       |           |       |              |       |      |       |
|                                                                   |                                       |                          |            |                |            |                  |            |                   |            |                |            |                   |            |           |            |  |  |  |  |  |  |  |  |

 

**Table12.**

** **

**LoanMaturities and Interest Rate Sensitivity**

As of December 31,2002

(Dollars inthousands)

 
|                        |   | **One Year  or Less** |   | **Between  One and  Five Years** |   | **After  Five Years** |   | **Total** |   |
|-----------------------------|--------|-----------------------|--------|----------------------------------|--------|-----------------------|--------|-----------|--------|
| Commercial & industrial |   | $                     | 58,659 |                             | $      | 73,875                |   | $         | 41,893 |   | $ | 174,427 |   |
| Residential                 |   | 2,725                 |   | 20,623                           |   | 8,460                 |   | 31,808    |   |
| Home equity lines           |   | 26,831                |   | —                           |   | —                |   | 26,831    |   |
| Construction                |   | 4,334                 |   | 1,447                            |   | —                |   | 5,781     |   |
| All other                   |   | 2,782                 |   | 3,741                            |   | 3,712                 |   | 10,235    |   |
| **Total loans receivable**  |   | $                     | 95,331 |                             | $      | 99,686                |   | $         | 54,065 |   | $ | 249,082 |   |
|                        |   |                  |   |                             |   |                  |   |      |   |
| Fixed - rate loans          |   |                  |   | $                                | 9,689  |                  | $      | 5,123     |   | $ | 14,812 |   |
| Floating - rate loans       |   |                  |   | 89,997                           |   | 48,942                |   | 138,939   |   |
| **Total loans receivable**  |   |                  |   | $                                | 99,686 |                  | $      | 54,065    |   | $ | 153,751 |   |

 

**Business Segment Operations**

 

We provide banking and non-banking financial servicesand products through our subsidiaries. Management operates and reports on the results of our operations throughtwo business segments, banking and investment advisory services.

 

36

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*Banking*

 

The banking segment provides comprehensive bankingservices to small businesses and individuals through multiple deliverychannels.  Services offered includecommercial and consumer lending, deposit products, and banking via the internetor telephone.

 

For the year ended December 31, 2002, the bankingsegment recorded a net loss of $16,000, compared to a recorded net loss of$10.2 million for the year ended December 31, 2001.  The decrease in the net loss for 2002 is a result of increasedearning assets and lower operating expenses. The results for 2001 included both the amortization and impairmentrecognition in goodwill.  Net interestincome, as our primary source of revenue, for the years ended December 31,2002, 2001, and 2000 were $10.6 million, $9.1 million and $5.9 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 and 2001 were $423.5million and $246.0 million, respectively.

* *

*Investment Advisory Services*

* *

The investment advisory services segment offersfinancial and estate planning services, centered on a group of productsprovided through a strategic alliance with Legg Mason Financial Partners, awholly owned subsidiary of Legg Mason, Inc. Operations for this segment began February 1, 1999.

 

For the years ended December 31, 2002, 2001 and 2000,the investment advisory services segment reported net losses of $205,000,$87,000 and $475,000, respectively. Investment fee income, as the primary source of revenue for thisreporting segment, for the years ended December 31, 2002, 2001 and 2000 were$940,000, $1.9 million and $1.5 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 of December 31, 2002 and 2001, total assets were$274,000 and $420,000, respectively. Total assets under management were $98.8 million and $102.2 million asof December 31, 2002 and 2001, respectively.

 

Information pertaining to both business segments canbe found in Footnote 15 to the Notes to Consolidated Financial Statements.

** **

**Quarterly Data**

** **

We recorded net income of$85,000 or $0.01 per common share for the fourth quarter of 2002, our secondconsecutive profitable quarter for 2002, as compared to a $2.48 loss per commonshare for the same period of 2001. Table 13 reflects quarterly data for the years ended December 31, 2002 and2001.

 

**Table13.**

 

**QuarterlyData**

Years endedDecember 31, 2002 and 2001

(Dollars inthousands, except per share data)

 
|                                                 |   | **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                                 |   | 1,107               |   | 728 |   | 642 |   | 796 |   |
| Non-interest  expense                                |   | 3,370               |   | 3,045 |   | 4,491 |   | 3,108 |   |
|                                                 |   |                |   |   |   |   |   |   |   |
| 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 | ) |

 
|                                                 |   | **2001**            |    |
|------------------------------------------------------|--------|---------------------|---------|
|                                                 |   | **Fourth  Quarter** |    | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
| Interest income                                      |   | $                   | 4,226   |   | $ | 4,213 |   | $ | 4,167 |   | $ | 3,971 |   |
| Interest expense                                     |   | 1,797               |    | 1,824 |   | 1,973 |   | 1,906 |   |
|                                                 |   |                |    |   |   |   |   |   |   |
| Net interest  income                                 |   | 2,429               |    | 2,389 |   | 2,194 |   | 2,065 |   |
| Provision for  loan losses                           |   | (826                | )       | (190 | ) | (129 | ) | (57 | ) |
|                                                 |   |                |    |   |   |   |   |   |   |
| Net interest  income after provision for loan losses |   | 1,603               |    | 2,199 |   | 2,065 |   | 2,008 |   |
| Non-interest  income                                 |   | 791                 |    | 854 |   | 970 |   | 652 |   |
| Non-interest  expense                                |   | 12,844              |    | 3,759 |   | 3,700 |   | 3,563 |   |
|                                                 |   |                |    |   |   |   |   |   |   |
| Net loss before  income taxes                        |   | (10,450             | )       | (706 | ) | (665 | ) | (903 | ) |
| Provision for  income taxes                          |   | —              |    | — |   | — |   | — |   |
| Net loss                                             |   | $                   | (10,450 | ) | $ | (706 | ) | $ | (665 | ) | $ | (903 | ) |
| Dividends to  preferred shareholders                 |   | 119                 |    | 128 |   | 128 |   | 128 |   |
| Net loss to  common shareholders                     |   | $                   | (10,569 | ) | $ | (834 | ) | $ | (793 | ) | $ | (1,031 | ) |
| Basic and  diluted loss per common share             |   | $                   | (2.48   | ) | $ | (0.20 | ) | $ | (0.19 | ) | $ | (0.24 | ) |

 

37

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**2001 Compared to 2000**

 

*Earnings Overview*

 

In the fourth quarter of2001 our net loss was $10.6 million, which included an impairment of $8.3million that effectively eliminated the goodwill associated with our mergerwith Heritage Bancorp, Inc.  Anevaluation of 2001 losses produced by Cardinal Bank — Potomac and expectationsof future additional losses indicated a potential impairment in our investmentin Heritage.  Loan and deposit growthswere materially less than what had been anticipated in our originalprojections.  The amount of theimpairment was determined through an independent appraisal of the remainingassets and liabilities of Heritage Bancorp, Inc. performed during the fourthquarter of 2001.  In addition,management refined its loan loss reserve methodology, which resulted in anadditional provision to our loan loss reserve of $774,000.  Additional costs relating to ourrestructuring totaled $829,000 during the last quarter of 2001.

 

Our net loss for the yearended December 31, 2001 totaled $13.2 million or ($3.11) per common share,compared with a loss of $4.1 million or ($0.98) per common share for the sameperiod of 2000.  The 2001 loss includedan impairment of $8.3 million that substantially eliminated the goodwillattributed to the purchase of Heritage Bancorp, Inc.  The return on average assets was (5.24%) in 2001 as compared to(2.72%) in 2000.  The return on averageequity was (39.14%) in 2001 as compared to (12.72%) in 2000.  Earnings per common share reflect thepayment of preferred dividends of $503,000 and $171,000 for the years ended December 31, 2001 and 2000, respectively.  Excluding the preferred dividends and thewrite down of goodwill, the loss for the year ended December 31, 2001 was $4.5million as compared to $4.1 million for the same period of 2000.  Table 1 shows a reconciliation of GAAP toNon-GAAP financial measures.

 

Total earning assetsincreased by 40.9% to $264.1 million at December 31, 2001 as compared to $187.3million at December 31, 2000.  Thisincrease consisted mainly of $46.6 million or 30.2% growth in total loans, netof fees and a $27.2 million increase in investment securitiesavailable-for-sale.   These increaseswere primarily funded by total deposit growth of $82.7 million or 50.6% overDecember 31, 2000 balances.

 

Operating results in 2001reflected significant increases in all income and expense categories due to ourgrowth.  We purchased Heritage Bancorp,Inc. and its sole operating subsidiary, The Heritage Bank, on September 1,2000, which contributed a full year of operating income and expenses in 2001 ascompared to four months in 2000.

 

Net interest income was$9.1 million in 2001, up $2.7 million from 2000 or 41.6%.  This increase was substantially due toincreased volume as the net interest margin had decreased.  The net interest margin was 4.17% for theyear ended December 31, 2001 as compared to 4.82% for the same period of2000.  The drop in interest rates by 475basis points during 2001 contributed to this decline as our earning assets haverepriced sooner than interest-bearing liabilities.   Average total loans increased $77.0 million to $181.0 million in2001 from $104.0 million in 2000, due to strong loan demand.  Average total deposits increased $91.5million to $197.4 million in 2001 from $105.9 million in 2000.

 

In 2001, the loan lossprovision of $1.2 million was $449,000 greater than the $753,000 recorded in2000 due partially to the increase in loan balances, both originated andacquired during 2001.  Of the $1.2million increase in loan loss reserves in 2001, $644,000 was due to increasesin loan balances, $157,000 was due to an increase in reserves specificallyallocated to one non-performing credit, and $399,000 was due to refinements inour loan loss methodology.

 

38

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Non-interest income was$3.3 million in 2001, a 55.7% increase compared to 2000.  The largest portion of this increase wasinvestment fee income from our subsidiary, Cardinal Wealth Services, Inc.,which increased to $1.9 million in 2001 from $1.5 million in 2000.  Service charges on deposit accountsincreased $244,000 to $398,000 during 2001 due to increased deposit accounts.

 

Non-interest expense was$23.9 million in 2001 compared to $11.7 million in 2000.  The 2001 increase included an impairment of$8.3 million that substantially eliminated the goodwill attributed to thepurchase of Heritage Bancorp, Inc. Additional expenses of approximately $884,000 in nonrecurring costsassociated with a corporate restructuring were included in 2001.

 

*Net Interest Income/Margin*

 

The net interest marginwas 4.17% for the year ended December 31, 2001 as compared to 4.82% for thesame period of 2000.  The Federal OpenMarket Committee decreased interest rates by 475 basis points during 2001contributing to a decline in the net interest margin as earning assets haverepriced sooner than interest-bearing liabilities.   The rate on interest earning assets decreased to 7.61% in 2001from 8.39% in 2000 and our cost of funds decreased to 3.13% in 2001 from 3.29%in 2000.  Average total loans increased$77.0 million to $181.0 million in 2001 from $104.0 million in 2000, due tostrong loan demand primarily in commercial loans and commercial real estateloans.  Average balances fornonperforming assets are included in the net interest margin calculation anddid not have a material impact on our net interest margin in 2001 and2000.  Additional interest income ofapproximately $17,000 for 2001 and $34,000 for 2000 would have been realizedhad all nonperforming assets performed as originally expected.  Nonperforming assets exclude loans that areboth past due 90 days or more and not deemed nonaccrual, due to an assessmentof collectibility.  Nonperforming assetsconsist of nonaccrual loans.  Averagetotal deposits increased $91.5 million to $197.4 million in 2001 from $105.9million in 2000.  Although all depositaccounts grew, the largest increase was in average certificates of deposit.

 

Tables 2 and 3 containmore detailed information concerning average balances, yields earned, and ratespaid.

 

*Provision and Allowance for Loan Losses*

 

The loan loss provisionwas $1.2 million in 2001 as compared to $753,000 in 2000 due partially to theincrease in loan balances, both originated and acquired during 2001.  In addition to the increased loan balances,we refined our loan loss reserve methodology during the fourth quarter of 2001,which, together with the growth in loan balances experienced during the fourthquarter, resulted in an additional provision of $774,000.  A specific reserve of $157,000 was recordedwithin the allowance for loan losses to reflect the non-performing status ofone credit in our loan portfolio.

 

The allowance for loanlosses increased to $3.1 million in 2001 from $1.9 million in 2000.  The ratio of the allowance for loan lossesto gross loans at December 31, 2001 was 1.54% compared to 1.23% at December 31,2000.  Of the $1.2 million increase inloan loss reserves in 2001, $644,000 was due to increases in loan balances,$157,000 was due to an increase in reserves specifically allocated to one non-performingcredit, and $399,000 was due to refinements in our loan loss reservemethodology.

 

From our inceptionthrough December 31, 2001, we had not experienced any loan losses, dueprimarily to the lack of maturity of our loan portfolio.  Under normal circumstances, we would basethe level of our loan loss reserves on actual loss experience. In the absenceof a history of actual loss experience, we had used peer group loss factors,adjusted by certain qualitative factors, including levels of and trends in

 

39

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delinquencies and nonaccrual loans, national and local economic trendsand conditions, and concentrations of loans exhibiting similar risk profiles.

 

During the fourth quarterof 2001, we refined our loan loss analysis in three ways:

 

•               We updated ourcomparative peer group to commercial banks located in Virginia, the District ofColumbia and Maryland with total assets of $250 million to $500 million tobetter reflect the anticipated consolidation of all banking subsidiaries intoone.  Prior to the fourth quarter of2001, peer group averages had been based on the Uniform Bank Performance Reportfor all commercial banks with assets of less than $100 million and wasconsistent with our prior structure of four separately chartered banks.

•               We adjusted peergroup loss averages by a “duration” factor beginning in the fourth quarter of2001, which had previously not been included in our analysis.

•               We elevated theimportance of qualitative factors in our analysis, due primarily to decliningeconomic conditions and an increase in our concentration in commercial realestate loans from 36% of the total loan portfolio as of December 31, 2000 to43% as of December 31, 2001. Under the revised analysis, qualitativeadjustments to loss factors ranged from 40 basis points on residentialmortgages to 95 basis points on commercial real estate loans.  Under the methodology used prior to thefourth quarter of 2001, qualitative adjustments had resulted in adjustingfactors ranging from zero to fifty basis points.

 

Tables 4 and 5 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.

 

*Loans Receivable*

 

Total loans, net of feesand premiums and discounts, increased $46.6 million to $200.9 million atDecember 31, 2001.  The strongest growthwas in commercial loans and commercial real estate loans reflecting ourstrength as a local small business community bank.

 

Our loan portfolio has aheavy commercial orientation as evidenced by the information provided in Table8.  We began in late 1999 to betterdiversify the loan portfolio by purchasing consumer loans.  We continued to diversify our portfolio in2000 and 2001 by purchasing consumer installment loans.

 

Loans receivableaccounted for on a non-accrual basis at December 31, 2001 and 2000 were$361,000 and $585,000, respectively. Accruing loans, which are contractually past due 90 days or more as toprincipal or interest payments as of December 31, 2001 and 2000, were $566,000and $2,000, respectively.  There are noloans as of December 31, 2001 and 2000 included above which are “troubled debtrestructurings.” Specific reserves of $157,000 were made in 2001 for one of thenon-accrual loans.  At December 31, 2001the ratio of non-performing loans to total loans was 0.18% as compared to 0.38%at December 31, 2000.  Table 9 presentsadditional information on nonperforming loans receivable.

 

*Non-Interest Income*

 

Non-interest income was$3.3 million for the year ended December 31, 2001, an increase of $1.2 millionover the same period of 2000.  Thelargest portion of this increase was investment fee income from our subsidiaryCardinal Wealth Services, Inc., which increased to $1.9 million in 2001 from$1.5 million in 2000.  Due to increaseddeposit accounts, service charges on deposit accounts increased $244,000 to$398,000 during 2001 as compared to $154,000 in 2000.  Loan service charges increased to $433,000 or 88.3% from $230,000in 2000 due to the increase in the loan portfolio.  During 2001, we consolidated

 

40

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operations, sublet the excess space and received rental income of$110,000 for that space.  Table 6provides additional detail on non-interest income for the years ended December31, 2002, 2001 and 2000.

 

*Non-Interest Expense*

 

Non-interest expense was$23.9 million and $11.7 million for the years ended December 31, 2001 and 2000,respectively.  The 2001 increaseincluded a one-time charge of $8.3 million that substantially eliminated thegoodwill attributed to the purchase of Heritage Bancorp, Inc. An evaluation of2001 year losses produced by Cardinal Bank — Potomac and expectations of futureadditional losses indicated a potential impairment in our investment inHeritage.  Loan and deposit growths werematerially less than what had been anticipated in our originalprojections.  Projections were based onhistorical growth under prior management and the experience of the Heritagelending group.  At September 30, 2001,total loans and deposits were $29.0 million and $22.0 million less than what wehad projected.  This differentialbetween actual and projected growth was partially due to the loss of customergenerating employees and the subsequent loss of their respectiveportfolios.  In the fourth quarter of2001, a valuation of Cardinal Bank — Potomac was performed by an externalconsultant in response to these impairment indicators.  The valuation was performed in compliancewith SFAS No. 121 and indicated a significant impairment, which resulted in thewrite down of goodwill of $8.3 million. Also, during 2001, we made the decision to restructure from four banksto one to simplify our structure and reduce costs. Consequently, included innon-interest expense is approximately $884,000 in non-recurring costsassociated with the restructuring.  Thisrestructuring was completed in the first quarter of 2002.  In addition, operating results in 2001 and2000 reflected significant increases in all income and expense categories dueto our growth.  Table 7 reflects thecomponents of non-interest expense for the years ended December 31, 2002, 2001and 2000.

 

*Investment Securities Available-for-Sale*

 

Investment securitiesincreased to $34.1 million at December 31, 2001 as compared to $6.9 million atDecember 31, 2000.  Our growth andsimplification of our structure have made more funds available forinvestments.  The portfolio yielddecreased from 6.60% as of December 31, 2000 to 5.36% as of December 31, 2001due to higher yielding investments maturing or being called.  Table 10 reflects the composition of theinvestment portfolio as of December 31, 2002, 2001 and 2000.

 

**Capital Resources**

 

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 agenciesmeasure capital adequacy utilizing a formula that takes into account the individualrisk profile of financial institutions. 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, 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 successful second quarter 2002 rights and secondarycommon stock 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

 

41

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preferred dividends paid and the net loss for 2002.  Book value per common share as December 31,2002 and 2001 was $3.37 and $3.21, respectively.

 

Footnote 10 to the Notesto Consolidated Financial Statements shows the minimum capital requirement andour capital position as of December 31, 2002 and 2001 for the bank holdingcompany.  Our regulatory capital levelsfor the bank and bank holding company meet those established forwell-capitalized institutions.

 

We expect to invest funds in the previously announced relocation of ourheadquarters to Tysons Corner, Virginia and branch acquisitions.  However, the lease on our current headquartersspace expires in 2004, and during the past year we have had success insubleasing other excess or vacated space. Moreover, the branches to be acquired are currently being used as bankbranches and can be converted to our use on a turnkey basis.  We are not acquiring (or paying for)deposits, and the branch acquisitions are spread over 2003 and 2004.

 

**Liquidity**

 

The objective ofliquidity management is to ensure the continuous availability of funds to meetthe demands 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, negotiablecertificates of deposit, securities sold under agreements to repurchase, andborrowings from the Federal Home Loan Bank enhance our liquidity.  Cash flows from operations, such as loanpayments and payoffs are also a significant source of liquidity.  We have a contingency plan that provides forcontinued monitoring of liquidity needs and available sources ofliquidity.  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, 2002, totaled$227.0 million.  Of that, $131.7 millionin investment securities available-for-sale were available as collateral foradditional Federal Home Loan Bank borrowings. Table 14 reflects the maturities of the certificates of deposit of$100,000 or more as of December 31, 2002.

 

**Table14.**

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

As of December 31, 2002

(Dollars in thousands)

 
|                                   |   | **2002** |   |
|----------------------------------------|--------|----------|--------|
| Maturities:                            |   |     |   |
| Three months or  less                  |   | $        | 10,759 |   |
| Over three  months through six months  |   | 8,716    |   |
| Over six months  through twelve months |   | 15,323   |   |
| Over twelve  months                    |   | 45,214   |   |
|                                   |   | $        | 80,012 |   |

 

**Forward****-LookingStatements And Risk Factors**

 

This Annual Reportcontains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934.  These forward-looking statementsare not historical facts, but rather are predictions and generally can beidentified by use of statements that include phrases such as “believe,”“expect,” “anticipate,” “estimate,” “intend,” “plan, “ “foresee” or other wordsor phrases of similar import. Similarly, statements that describe our future financial condition orresults of operations, objectives, strategies, plans, goals or futureperformance and business also are forward-looking statements.  These forward-looking statements involveknown and unknown risks, uncertainties and other factors, including thosedescribed in our Registration Statement on Form SB-2, as amended, as filed withthe SEC on February 19, 2002, that could cause our actual results todiffer materially from those currently anticipated in these

 

42

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forward-looking statements.  Inlight of these risks and uncertainties, the forward-looking events might ormight not occur.

 

Important factors that could cause actual results to differ materiallyfrom those suggested by these forward-looking statements, and could adverselyaffect our future financial performance, include the success of pending effortsto raise capital and the following:

 

•               We have neveroperated profitably for a full year and may not be able to do so in the future.

 

•               Our businessstrategy calls for continued expansion. We may not be able to maintain and manage our growth.

 

•               We depend on theservices of key personnel.  We cannot becertain we will be able to retain such personnel or hire replacements, and aloss of any of those personnel could disrupt our operations.

 

•               We may not be ableto attract, hire, motivate and retain personnel necessary for theimplementation of our revised business strategy.

 

•               We may be unable toprovide new financial products and services required by banking industrychanges and demanded by our customers.

 

•               Many of our loansare secured by real estate (both residential and commercial) in our marketarea.  Our concentration in loanssecured by real estate may increase our credit losses.

 

•               We maintain anallowance for loan losses that we believe is a reasonable estimate of known andinherent losses in our loan portfolio. However, our allowance for loan losses could become inadequate.

 

•               Our business isdependent on technology; an inability to invest in technological improvementsmay adversely affect our results of operation.

 

•               Our profitabilitywill depend in substantial part upon the spread between the interest ratesearned on investments and loans and interest rates paid on deposits and otherinterest-bearing liabilities.  Ourprofitability may suffer if we are unable to successfully manage interest raterisk.

 

•               Our profitabilitydepends significantly on economic conditions in our Northern Virginia marketarea.

 

•               Our profitabilitymay suffer because of rapid and unpredictable changes in the highly regulatedenvironment in which we operate.

 

•               Our businessstrategy calls for continued growth.  Ifwe need capital in the future to continue our growth, we may not be able toobtain it on terms that are favorable.

 

•               Weplan to consider potential acquisitions of other banks.  We cannot assure you that we will be able toidentify any attractive acquisition candidates or, if we can identify them,that we will be able to finance the acquisitions or acquire them on attractiveterms.

 

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**Item7****.                   FinancialStatements**

 

The following financial statements of CardinalFinancial Corporation (the “Company”) are filed as part of this report:

 

Independent Auditors’ Report of KPMG LLP

 

ConsolidatedStatements of Condition as of December 31, 2002 and 2001

 

Consolidated Statements ofOperations for the years ended December 31, 2002, 2001 and 2000

 

ConsolidatedStatements of Comprehensive Income (Loss) for the years ended December 31,2002, 2001 and 2000

 

ConsolidatedStatements of Changes in Shareholders’ Equity for the years ended December 31,2002, 2001 and 2000

 

ConsolidatedStatements of Cash Flows for the years ended December 31, 2002, 2001 and 2000

 

Notes toConsolidated Financial Statements

 

44

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The Board of Directorsand Shareholders

Cardinal FinancialCorporation and subsidiaries:

 

We have audited theaccompanying consolidated statements of condition of Cardinal FinancialCorporation and subsidiaries (the Company) as of December 31, 2002 and 2001,and the related consolidated statements of operations, comprehensive income(loss), changes in shareholders’ equity, and cash flows for each of the yearsin the three-year period ended December 31, 2002.  These consolidated financial statements are the responsibility ofthe Company’s management.  Our responsibilityis to express an opinion on these consolidated financial statements based onour audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America.  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Cardinal Financial Corporation andsubsidiaries as of December 31, 2002 and 2001, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2002, in conformity with accounting principles generallyaccepted in the United States of America.

 

 

/s/KPMG LLP

 

McLean, Virginia

January 15, 2003

 

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**ConsolidatedStatements of Condition as of December 31, 2002 and 2001**

 

**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATED STATEMENTS OFCONDITION

 

December31, 2002 and 2001

 

(Dollarsin thousands, except share data)

 
|                                                                                                                                  |   | **2002** |    | **2001** |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|
| **Assets**                                                                                                                            |   |     |    |     |   |
| Cash and due from banks                                                                                                               |   | $        | 27,465  |     | $      | 11,446 |   |
| Federal funds sold                                                                                                                    |   | 35,906   |    | 23,013   |   |
|                                                                                                                                  |   |     |    |     |   |
| Total cash and cash equivalents                                                                                                       |   | 63,371   |    | 34,459   |   |
|                                                                                                                                  |   |     |    |     |   |
| Investment securities available-for-sale                                                                                              |   | 163,665  |    | 34,147   |   |
| Other investments                                                                                                                     |   | 1,615    |    | 1,268    |   |
| Loans held for sale                                                                                                                   |   | —   |    | 4,732    |   |
|                                                                                                                                  |   |     |    |     |   |
| Loans receivable, net of fees                                                                                                         |   | 249,106  |    | 200,911  |   |
| Allowance for loan losses                                                                                                             |   | (3,372   | )       | (3,104   | )      |
|                                                                                                                                  |   |     |    |     |   |
| Loans receivable, net                                                                                                                 |   | 245,734  |    | 197,807  |   |
|                                                                                                                                  |   |     |    |     |   |
| Premises and equipment, net                                                                                                           |   | 4,942    |    | 5,077    |   |
| Goodwill and other intangibles, net                                                                                                   |   | 646      |    | 668      |   |
| Accrued interest and other assets                                                                                                     |   | 6,350    |    | 1,426    |   |
|                                                                                                                                  |   |     |    |     |   |
| Total assets                                                                                                                          |   | $        | 486,323 |     | $      | 279,584 |   |
|                                                                                                                                  |   |     |    |     |   |
| **Liabilities  and Shareholders’ Equity**                                                                                        |   |     |    |     |   |
|                                                                                                                                  |   |     |    |     |   |
| Deposits                                                                                                                              |   | $        | 423,479 |     | $      | 246,024 |   |
| Other borrowed funds                                                                                                                  |   | 2,000    |    | 9,824    |   |
| Accrued interest and other liabilities                                                                                                |   | 20,132   |    | 3,112    |   |
|                                                                                                                                  |   |     |    |     |   |
| Total liabilities                                                                                                                     |   | 445,611  |    | 258,960  |   |
|                                                                                                                                  |   |     |    |     |   |
|                                                                                                                                  |   |     |    |     |   |
| Preferred stock, $1 par value, 10,000,000 shares authorized:                                                                          |   | 1,365    |    | 1,365    |   |
| Series A preferred stock, cumulative convertible, 1,364,684 and  1,364,714 shares outstanding in 2002 and 2001, respectively          |   |     |    |     |   |
| Common stock, $1 par value, 50,000,000 shares authorized, 10,044,345  and 4,294,323 shares outstanding in 2002 and 2001, respectively |   | 10,044   |    | 4,294    |   |
| Additional paid-in capital                                                                                                            |   | 51,231   |    | 38,488   |   |
| Accumulated deficit                                                                                                                   |   | (24,273  | )       | (23,249  | )      |
| Accumulated other comprehensive income (loss)                                                                                         |   | 2,345    |    | (274     | )      |
|                                                                                                                                  |   |     |    |     |   |
| Total shareholders’ equity                                                                                                       |   | 40,712   |    | 20,624   |   |
|                                                                                                                                  |   |     |    |     |   |
| Total liabilities and shareholders’ equity                                                                                       |   | $        | 486,323 |     | $      | 279,584 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

46

----

 

**ConsolidatedStatements of Operations for the years ended December 31, 2002, 2001 and 2000**

 

**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATED STATEMENTSOF OPERATIONS

 

Yearsended December 31, 2002, 2001 and 2000

(Inthousands, except per share data)

 

 
|                                                                 |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Interest income:                                                     |   |     |   |     |   |     |   |
| Loans receivable                                                     |   | $        | 14,798 |     | $      | 14,973   |   | $ | 9,258 |   |
| Federal funds sold                                                   |   | 871      |   | 1,085    |   | 1,451    |   |
| Investment securities available-for-sale                             |   | 4,501    |   | 437      |   | 371      |   |
| Other investments                                                    |   | 72       |   | 82       |   | 70       |   |
|                                                                 |   |     |   |     |   |     |   |
| Total interest income                                                |   | 20,242   |   | 16,577   |   | 11,150   |   |
|                                                                 |   |     |   |     |   |     |   |
| Interest expense:                                                    |   |     |   |     |   |     |   |
| Deposits                                                             |   | 9,364    |   | 7,027    |   | 4,293    |   |
| Other borrowed funds                                                 |   | 222      |   | 473      |   | 447      |   |
|                                                                 |   |     |   |     |   |     |   |
| Total interest expense                                               |   | 9,586    |   | 7,500    |   | 4,740    |   |
|                                                                 |   |     |   |     |   |     |   |
| Net interest income                                                  |   | 10,656   |   | 9,077    |   | 6,410    |   |
|                                                                 |   |     |   |     |   |     |   |
| Provision for loan losses                                            |   | 444      |   | 1,202    |   | 753      |   |
|                                                                 |   |     |   |     |   |     |   |
| Net interest income after provision for loan losses                  |   | 10,212   |   | 7,875    |   | 5,657    |   |
|                                                                 |   |     |   |     |   |     |   |
| Non-interest income:                                                 |   |     |   |     |   |     |   |
| Service charges on deposit accounts                                  |   | 511      |   | 398      |   | 154      |   |
| Loan service charges                                                 |   | 392      |   | 433      |   | 230      |   |
| Investment fee income                                                |   | 940      |   | 1,941    |   | 1,516    |   |
| Net gain (loss) on sales of loans                                    |   | 74       |   | 49       |   | (23      | )      |
| Net realized gain (loss) on investment securities available-for-sale |   | 524      |   | —   |   | (32      | )      |
| Net gain on sales of assets                                          |   | 39       |   | 18       |   | 57       |   |
| Other income                                                         |   | 793      |   | 428      |   | 196      |   |
|                                                                 |   |     |   |     |   |     |   |
| Total non-interest income                                            |   | 3,273    |   | 3,267    |   | 2,098    |   |
|                                                                 |   |     |   |     |   |     |   |
| Non-interest expense:                                                |   |     |   |     |   |     |   |
| Salary and benefits                                                  |   | 5,715    |   | 7,731    |   | 6,317    |   |
| Occupancy                                                            |   | 1,381    |   | 1,373    |   | 1,075    |   |
| Professional fees                                                    |   | 1,011    |   | 705      |   | 508      |   |
| Depreciation                                                         |   | 736      |   | 804      |   | 601      |   |
| Writedown on WorldCom bond                                           |   | 1,660    |   | —   |   | —   |   |
| Amortization and write down of intangibles                           |   | 22       |   | 8,907    |   | 235      |   |
| Other operating expenses                                             |   | 3,489    |   | 4,346    |   | 2,990    |   |
|                                                                 |   |     |   |     |   |     |   |
| Total non-interest expense                                           |   | 14,014   |   | 23,866   |   | 11,726   |   |
|                                                                 |   |     |   |     |   |     |   |
| Net loss before income taxes                                         |   | (529     | )      | (12,724  | )      | (3,971   | )      |
|                                                                 |   |     |   |     |   |     |   |
| Provision for income taxes                                           |   | —   |   | —   |   | —   |   |
|                                                                 |   |     |   |     |   |     |   |
| Net loss                                                             |   | $        | (529   | )        | $      | (12,724  | )      | $ | (3,971 | ) |
|                                                                 |   |     |   |     |   |     |   |
| Dividends to preferred shareholders                                  |   | 495      |   | 503      |   | 171      |   |
|                                                                 |   |     |   |     |   |     |   |
| Net loss to common shareholders                                      |   | $        | (1,024 | )        | $      | (13,227  | )      | $ | (4,142 | ) |
|                                                                 |   |     |   |     |   |     |   |
| Basic and diluted loss per common share                              |   | $        | (0.13  | )        | $      | (3.11    | )      | $ | (0.98 | ) |
|                                                                 |   |     |   |     |   |     |   |
| Weighted-average common shares outstanding                           |   | 7,949    |   | 4,258    |   | 4,246    |   |

 

See accompanying notes to consolidatedfinancial statements.

 

47

----

 

**ConsolidatedStatements of Comprehensive Income(Loss) for the years ended December 31, 2002,2001 and 2000**

 

**CARDINALFINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTSOF COMPREHENSIVE INCOME (LOSS)

Years ended December 31,2002, 2001 and 2000

(Dollars in thousands)

 
|                                                                       |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                       |   |     |   |     |   |     |   |
| Net loss                                                                   |   | $        | (529   | )        | $      | (12,724  | )      | $ | (3,971 | ) |
| Other  comprehensive income (loss):                                        |   |     |   |     |   |     |   |
| Unrealized gain  (loss) on available-for-sale investment securities:       |   |     |   |     |   |     |   |
| Unrealized  holding gain (loss) arising during the year                    |   | 3,143    |   | (278     | )      | 85       |   |
| Less:  reclassification adjustment for gains (losses) included in net loss |   | 524      |   | —   |   | (32      | )      |
|                                                                       |   |     |   |     |   |     |   |
| Comprehensive  income (loss)                                               |   | $        | 2,090  |     | $      | (13,002  | )      | $ | (3,854 | ) |

 

See accompanying notes to consolidated financial statements.

 

48

----

 

**ConsolidatedStatements of Changes in Shareholders' Equity for the years ended December 31,2002, 2001 and 2000**

 

**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Yearsended December 31, 2002, 2001 and 2000

(Dollarsin thousands)

 
|                                                                          |   | **Preferred  Shares** |   | **Preferred  Stock** |   | **Common  Shares** |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Accumulated  Deficit** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Total** |   |
|-------------------------------------------------------------------------------|--------|-----------------------|--------|----------------------|--------|--------------------|--------|-------------------|--------|----------------------------------|--------|--------------------------|--------|------------------------------------------------------|--------|-----------|--------|
| Balance, December 31, 1999                                                    |   | —                |   | $                    | 4,243  |               | $      | 4,243             |   | $                                | 32,496 |                     | $      | (5,881                                               | )      | $         | (113   | ) | $ | 30,745 |   |   |   |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Issuance of 1,411,499 shares of cumulative preferred stock, par value  $1     |   | 1,411                 |   | 1,411                |   | —             |   | —            |   | 5,645                            |   | —                   |   | —                                               |   | 7,056     |   |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Issuance of common stock options in connection with acquisition               |   | —                |   | —               |   | —             |   | —            |   | 301                              |   | —                   |   | —                                               |   | 301       |   |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Stock options exercised                                                       |   | —                |   | —               |   | 7                  |   | 7                 |   | 15                               |   | —                   |   | —                                               |   | 22        |   |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Issuance of stock awards                                                      |   | —                |   | —               |   | 3                  |   | 3                 |   | 9                                |   | —                   |   | —                                               |   | 12        |   |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Dividends on preferred stock                                                  |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (170                     | )      | —                                               |   | (170      | )      |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Change in unrealized gain (loss) on investment securities  available-for-sale |   | —                |   | —               |   | —             |   | —            |   | —                           |   | —                   |   | 117                                                  |   | 117       |   |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| Net loss                                                                      |   | —                |   | —               |   | —             |   | —            |   | —                           |   | (3,971                   | )      | —                                               |   | (3,971    | )      |
|                                                                          |   |                  |   |                 |   |               |   |              |   |                             |   |                     |   |                                                 |   |      |   |
| 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 |   |
|                                                                               |        |                       |        |                      |        |                    |        |                   |        |                                  |        |                          |        |                                                      |        |           |        |  |  |  |  |  |  |  |

 

See accompanying notes to consolidatedfinancial statements.

 

49

----

 

**ConsolidatedStatements of Cash Flows for the years ended December 31, 2002, 2001 and 2000**

 

**CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES**

 

CONSOLIDATED STATEMENTS OFCASH FLOWS

 

Yearsended December 31, 2002, 2001 and 2000

 

(Dollarsin thousands)

 
|                                                                                                                                                                                  |   | **2002** |   | **2001** |   | **2000** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash flows from operating activities:                                                                                                                                                 |   |     |   |     |   |     |   |
| Net loss                                                                                                                                                                              |   | $        | (529   | )        | $      | (12,724  | )      | $ | (3,971 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities:                                                                                            |   |     |   |     |   |     |   |
| Depreciation                                                                                                                                                                          |   | 736      |   | 804      |   | 600      |   |
| Amortization and writedown of intangibles, premiums and discounts                                                                                                                     |   | 1,120    |   | 8,960    |   | 230      |   |
| Provision for loan losses                                                                                                                                                             |   | 444      |   | 1,202    |   | 753      |   |
| Originations of loans held for sale                                                                                                                                                   |   | (4,369   | )      | (15,807  | )      | 1,275    |   |
| Proceeds from the sale of loans held for sale                                                                                                                                         |   | 9,175    |   | 11,124   |   | (1,252   | )      |
| Writedown on WorldCom bond                                                                                                                                                            |   | 1,660    |   | —   |   | —   |   |
| (Gain) loss on sale of investment securities available-for-sale                                                                                                                       |   | (524     | )      | —   |   | 32       |   |
| Gain on sale of other assets                                                                                                                                                          |   | (113     | )      | (67      | )      | (48      | )      |
| (Increase) decrease in accrued interest and other assets                                                                                                                              |   | (4,924   | )      | 117      |   | (1,082   | )      |
| Increase in accrued interest and other liabilities                                                                                                                                    |   | 17,020   |   | 834      |   | 1,268    |   |
| Compensation related to stock awards                                                                                                                                                  |   | —   |   | 6        |   | 12       |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Net cash provided by (used in) operating activities                                                                                                                                   |   | 19,696   |   | (5,551   | )      | (2,183   | )      |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Cash flows from investing activities:                                                                                                                                                 |   |     |   |     |   |     |   |
| Purchase of premises and equipment                                                                                                                                                    |   | (601     | )      | (501     | )      | (1,456   | )      |
| Proceeds from sale of premises and equipment                                                                                                                                          |   | —   |   | 28       |   | 175      |   |
| Proceeds from sale, maturity and call of investment securities  available-for-sale                                                                                                    |   | 42,034   |   | 4,500    |   | 2,468    |   |
| Proceeds from sale of other investments                                                                                                                                               |   | 188      |   | 832      |   | —   |   |
| Purchase of investment securities available-for-sale                                                                                                                                  |   | (197,255 | )      | (34,101  | )      | —   |   |
| Purchase of other investments                                                                                                                                                         |   | (535     | )      | (587     | )      | (133     | )      |
| Redemptions of investment securities available-for-sale                                                                                                                               |   | 25,564   |   | 2,111    |   | 421      |   |
| Net increase in loans receivable                                                                                                                                                      |   | (47,808  | )      | (46,458  | )      | (48,244  | )      |
| Net cash acquired in acquisition                                                                                                                                                      |   | —   |   | —   |   | 11,090   |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Net cash used in investing activities                                                                                                                                                 |   | (178,413 | )      | (74,176  | )      | (35,679  | )      |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Cash flows from financing activities:                                                                                                                                                 |   |     |   |     |   |     |   |
| Net increase in deposits                                                                                                                                                              |   | 177,455  |   | 82,653   |   | 49,600   |   |
| Net increase (decrease) in other borrowed funds                                                                                                                                       |   | (7,824   | )      | 2,537    |   | (1,145   | )      |
| Proceeds from rights offering                                                                                                                                                         |   | 7,899    |   | —   |   | —   |   |
| Proceeds from public offering                                                                                                                                                         |   | 10,594   |   | —   |   | —   |   |
| Dividends on preferred stock                                                                                                                                                          |   | (495     | )      | (503     | )      | (170     | )      |
| Stock options exercised                                                                                                                                                               |   | —   |   | 11       |   | 22       |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Net cash provided by financing activities                                                                                                                                             |   | 187,629  |   | 84,698   |   | 48,307   |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Net increase in cash and cash equivalents                                                                                                                                             |   | 28,912   |   | 4,971    |   | 10,445   |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Cash and cash equivalents at beginning of year                                                                                                                                        |   | 34,459   |   | 29,488   |   | 19,043   |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| Cash and cash equivalents at end of year                                                                                                                                              |   | $        | 63,371 |     | $      | 34,459   |   | $ | 29,488 |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| **Supplemental disclosure of cash flow information:**                                                                                                                                 |   |     |   |     |   |     |   |
| Cash paid during year for interest                                                                                                                                                    |   | $        | 9,491  |     | $      | 7,538    |   | $ | 4,676 |   |
|                                                                                                                                                                                  |   |     |   |     |   |     |   |
| **Supplemental schedule of noncash investing and  financing activities:**                                                                                                             |   |     |   |     |   |     |   |
| In 2000, the Company purchased all of the common stock of Heritage  Bancorp, Inc. for $14.4 million.  In  conjunction with the acquisition, liabilities were assumed as follows: |   |     |   |     |   |     |   |
| Fair value of assets acquired                                                                                                                                                         |   |     |   |     |   | $        | 62,162 |   |
| Goodwill and other intangibles                                                                                                                                                        |   |     |   |     |   | 9,812    |   |
| Cash paid                                                                                                                                                                             |   |     |   |     |   | (7,059   | )      |
| Preferred stock issued                                                                                                                                                                |   |     |   |     |   | (7,056   | )      |
| Issuance of common stock options                                                                                                                                                      |   |     |   |     |   | (301     | )      |
| Fair value of liabilities assumed                                                                                                                                                     |   |     |   |     |   | $        | 57,558 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

50

----

 

**Notesto Consolidated Financial Statements**

 

(1)           Organization

 

Cardinal Financial Corporation (the ”Company”)was incorporated November 24, 1997 under the laws of the Commonwealth ofVirginia as a holding company whose activities consist of investment in itswholly-owned subsidiaries.  In additionto Cardinal Bank, N.A., which began operations in 1998, the Company opened thefollowing three subsidiaries in 1999, Cardinal *Wealth Services, Inc.* aninvestment subsidiary (as of February 1, 1999), Cardinal Bank – *Manassas/PrinceWilliam*, N.A. (as of July 26, 1999), and Cardinal Bank – *Dulles*,N.A. (as of August 2, 1999).  OnSeptember 1, 2000, the Company completed its acquisition of Heritage Bancorp,Inc. and its banking subsidiary, The Heritage Bank, headquartered in McLean,Virginia.  The Heritage Bank was renamedand became the Company’s fourth banking subsidiary, Cardinal Bank – *Potomac*.  On November 1, 2001, the Companyconsolidated two of its banking subsidiaries, Cardinal Bank – *Dulles*,N.A. and Cardinal Bank – *Potomac* into Cardinal Bank, N.A.  On March 1, 2002, the Company consolidatedCardinal Bank – *Manassas/ Prince William,* N.A. into Cardinal Bank, N.A., theCompany’s only remaining banking subsidiary.

 

(2)           Summary ofSignificant Accounting Policies

 

(a)           *Use of Estimates*

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosures of contingent assets andcontingent liabilities at the date of the consolidated financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.  Material estimates that areparticularly susceptible to changes in the near term are the allowance for loanlosses, the valuation of deferred tax assets, and the determination ofimpairment on investment securities.

 

(b)           *Principles of Consolidation*

 

The consolidated financial statements include theaccounts of the Company and its subsidiaries. All significant intercompany transactions and balances have beeneliminated in consolidation.

 

(c)           *Cash and Cash Equivalents*

 

For the purpose of presentation in the consolidatedstatements of cash flows, the Company has defined cash and cash equivalents asthose amounts included in cash, due from banks, and federal funds sold.

 

(d)           *Investment Securities*

 

The Company classifies its debt and marketable equitysecurities in one of two categories: available-for-sale or held-to-maturity. Held-to-maturity securities are those securities for which the Company hasthe ability and intent to hold until maturity. All other securities are classified as available-for-sale.

 

51

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Held to maturity securities are held at cost.  Available-for-sale securities are recordedat fair value.  Unrealized gains andlosses, net of tax if applicable, on available-for-sale securities are reportedin other comprehensive income (loss).

 

Gains and losses on the sale of securities aredetermined using the specific identification method.  Declines in the fair value of individual held-to-maturity andavailable-for-sale securities below their cost that are deemed other thantemporary are charged to earnings as realized losses, resulting in theestablishment of a new cost basis for the security.

 

Premiums and discounts are recognized in interestincome using the effective interest method over the period to maturity.  Prepayment of the mortgages securing themortgage-backed securities may affect the maturity date and yield tomaturity.  The Company uses actualprincipal prepayment experience and estimates of future principal prepaymentsin calculating the yield necessary to apply the effective interest method.

 

(e)           *Loans Held for Sale*

 

Loans originated and intended for sale in thesecondary market are carried at the lower of cost or estimated fair value on anindividual loan basis as determined by outstanding commitments frominvestors.  Net unrealized losses, ifany, are recognized through a valuation allowance by charges tooperations.  Cost basis includes unpaidprincipal balances, origination premiums or discounts, and deferred net fees orcosts.

 

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

 

Loans receivable that management has the intent andability to hold for the foreseeable future or until maturity or pay-off arereported at their outstanding principal balance adjusted for any charge-offs,and net of the allowance 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.

 

Loans are placed in nonaccrual status when they arepast-due 90 days as to either principal or interest or when, in theopinion of management, the collection of principal and interest is indoubt.  A loan remains in nonaccrualstatus until the loan is current as to payment of both principal and interestor past-due less than 90 days, and the borrower demonstrates the abilityto pay and remain current.  Loans arecharged-off when a loan or a portion thereof is considered uncollectible.  When cash payments are received, they areapplied to principal first, then accrued interest.  It is the Company’s policy not to record interest income onnonaccrual loans until principal has become current.

 

The Company determines and recognizes impairment ofcertain loans when, based on current information and events, it is probablethat the Company will be unable to collect all amounts due according to thecontractual terms of the loan agreement. A loan is not considered impaired during a period of delay in payment ifthe Company expects to collect all amounts due, including past-dueinterest.  An impaired loan is measuredat the present value of its expected future cash flows discounted at the loan’seffective interest rate, or at the loan’s observable market price or fair valueof the collateral if the loan is collateral dependent.

 

The allowance for loan losses is increased byprovisions for loan losses and decreased by charge-offs (net ofrecoveries).  Management’s periodicdetermination of the allowance is based on the Company’s past loan lossexperience, adverse situations that may affect the

 

52

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borrower’s ability to repay, the estimated value ofany underlying collateral, and current economic conditions.  In addition, various regulatory agencies, asan integral part of their examination process, periodically review theCompany’s allowance for loan losses. Such agencies may require the Company to recognize additions to theallowance based on their judgments about information available to them at thetime of their examination.  Managementbelieves that the current allowance for loan losses is a reasonable estimate ofknown and inherent losses in the current loan portfolio.

 

(g)           *Premises and Equipment*

 

Land is carried at cost.  Premises, furniture, equipment, and leasehold improvements arecarried at cost, less accumulated depreciation and amortization. Depreciationof premises, furniture and equipment is computed using the straight-line methodover their estimated useful lives from 3 to 10 years. Amortization of leaseholdimprovements is computed using the straight-line method over the useful livesof the improvements or the lease term, whichever is shorter.

 

(h)           *Goodwill and Other Intangibles*

 

Goodwill, which represents the excess of purchaseprice over fair value of net assets acquired, is evaluated at least annuallyfor impairment by comparing its fair value with its recorded amount and iswritten-down when appropriate. Projected undiscounted net operating cash flows are compared to thecarrying amount of the goodwill recorded and if the estimated undiscounted netoperating cash flows are less than the carrying amount, a loss is recognized toreduce the carrying amount to fair value.  In 2002, 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, 2002.

 

(i)            *Investment Fee Income*

 

Investment fee income representscommissions paid by customers of Cardinal *Wealth Services,**Inc.* for investmenttransactions.  Fees are recognized inincome as they are earned.

 

(j)            *Income Taxes*

 

Deferred tax assets and liabilities are reflected at currentlyenacted income tax rates applicable to the period in which the deferred taxassets or liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted,deferred tax assets and liabilities are adjusted through the provision forincome taxes.

 

(k)           *Loss Per Common Share*

 

Basic and diluted loss per common share is computed bydividing net loss by the weighted average number of shares of common stockoutstanding during the periods.  Commonstock equivalents outstanding at December 31, 2002, 2001 and 2000 wereantidilutive and consequently not included in the loss per common sharecalculation.

 

(l)            *Stock Option Plan*

 

The Company applies the intrinsic value-based methodof accounting prescribed by Accounting Principles Board (“APB”) OpinionNo. 25, *Accounting for Stock Issued to*

 

53

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*Employees*, and related interpretations, inaccounting for its fixed plan stock options. As such, compensation expense is recorded only if the current marketprice of the underlying stock exceeded the exercise price on the date of grant.

 

(m)          *Stock Based Compensation*

 

At December 31, 2002, the Company had two stock-basedemployee compensation plans, which are described more fully in Footnote14.  As permitted under SFAS No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure*, whichamended 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 ofAPB  No. 25.  The following table illustrates the effect on net loss and lossper common share if the Company had applied the

 
|                                               |                                                                                                     | **Year ended  December 31,** |   |
|----------------------------------------------------|----------------------------------------------------------------------------------------------------------|------------------------------|--------|
| **(Dollars in  thousands, except per share data)** |                                                                                                     | **2002**                     |   | **2001** |   | **2000** |   |
| Net loss to  common shareholders as reported       |                                                                                                     | $                            | (1,024 | ) | $ | (13,227 | ) | $ | (4,142 | ) |
| Deduct:                                            | Total stock  based employee compensation expense dtermined under fair value-based method  for all awards |                         | (265   | ) | (138 | ) | (120 | ) |
|                                               |                                                                                                     |                         |   |   |   |   |   |
| Pro forma net  loss                                |                                                                                                     | $                            | (1,289 | ) | $ | (13,365 | ) | $ | (4,262 | ) |
|                                               |                                                                                                     |                         |   |   |   |   |   |
| Loss per common  share:                            |                                                                                                     |                         |   |   |   |   |   |
|                                               | Basic - as reported                                                                                      |                         | $      | (0.13 | ) | $ | (3.11 | ) | $ | (0.98 | ) |
|                                               | Basic - pro forma                                                                                        |                         | (0.16  | ) | (3.14 | ) | (1.00 | ) |
|                                               | Diluted - as reported                                                                                    |                         | (0.13  | ) | (3.11 | ) | (0.98 | ) |
|                                               | Diluted - pro forma                                                                                      |                         | (0.16  | ) | (3.14 | ) | (1.00 | ) |
|                                                    |                                                                                                          |                              |        |  |  |  |  |  |  |  |  |  |

 

 

fair value recognition provisions of SFAS No. 123 tostock-based employee compensation.

 

The weighted average per share fair values of grantsmade in 2002, 2001 and 2000 plans were $2.12, $2.04 and $2.23,respectively.  The fair values of theoptions granted were estimated on the grant date using the Black-Scholesoption-pricing model based on the following weighted average assumptions:

 
|                     |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------|--------|----------|--------|----------|--------|----------|--------|
|                     |   |     |   |     |   |     |   |
| Estimated option  life   |   | 10 years |   | 10 years |   | 10 years |   |
| Risk free  interest rate |   | 4.25     | %      | 4.90     | %      | 6.54     | %      |
| Expected  volatility     |   | 20.4     | %      | 36.3     | %      | 33.5     | %      |
| Expected  dividend yield |   | 0.00     | %      | 0.00     | %      | 0.00     | %      |

 

54

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(n)           *Reclassifications*

 

Certain amounts for 2001 and 2000 have beenreclassified to conform to the presentation for 2002.

 

 

(3)           InvestmentSecurities and Other Investments

 

The fair value and amortized cost of available-for-salesecurities as of December 31, 2002 and 2001 are shown below.

 
|                                                               |   | **2002**        |       |
|--------------------------------------------------------------------|--------|-----------------|------------|
| **(Dollars in thousands)**                                         |   | **Fair  value** |       | **Amortized  cost** |   |
| Obligations of U.S.  government-sponsored agencies and enterprises |   | $39,036         |       | $38,787 |   |
| Mortgage-backed securities                                         |   | 117,079         |       | 115,026 |   |
| Other bonds                                                        |   | 5,000           |       | 5,000 |   |
| Treasury bonds                                                     |   | 2,550           |       | 2,507 |   |
| Total                                                              |   | $163,665        |       | $161,320 |   |
|                                                               |   |            |       |   |   |
|                                                               |   | **2001**        | ** ** |
| **(Dollars in  thousands)**                                        |   | **Fair  value** | ** ** | **Amortized  cost** | ** ** |
| Obligations of U.S.  government-sponsored agencies and enterprises |   | $4,458          |       | $4,501 |   |
| Mortgage-backed securities                                         |   | 22,357          |       | 22,530 |   |
| Corporate bonds                                                    |   | 7,083           |       | 7,140 |   |
| Treasury bonds                                                     |   | 249             |       | 250 |   |
| Total                                                              |   | $34,147         |       | $34,421 |   |

 

 

The fair value and amortized cost of available-for-salesecurities by contractual maturity at December 31, 2002 is shownbelow.  Expected maturities may differfrom contractual maturities because many issuers have the right to call orprepay obligations with or without call or prepayment penalties.

 
|                               |   | **2002**        |   |
|------------------------------------|--------|-----------------|--------|
| **(Dollars in thousands)**         |   | **Fair  value** |   | **Amortized  cost** |   |
| After 1 year but within 5 years    |   | $29,538         |   | $29,246 |   |
| After 5 years but within 10  years |   | 12,048          |   | 12,048 |   |
| After 10 years                     |   | 5,000           |   | 5,000 |   |
| Mortgage-backed securities         |   | 117,079         |   | 115,026 |   |
| Total                              |   | $163,665        |   | $161,320 |   |

 

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For the years ended December31, 2002, 2001, and 2000, proceeds from sales of investment securitiesavailable-for-sale amounted to $31.3 million, $0, and $2.5 million,respectively.  Gross realized gains in2002 amounted to $544,000.  There wereno realized gains during 2001 and 2000. Gross realized losses during 2002, 2001 and 2000 amounted to $20,000, $0and $32,000, respectively.  Thefollowing table presents gross unrealized gains and losses in the investmentsecurities available-for-sale portfolio as of December 31, 2002 and 2001.

 
|                               |   | **2002**      |       |
|------------------------------------|--------|---------------|------------|
|                               |   | **Amortized** |       | **Gross  Unrealized** |   | **Fair** |   |
| **(Dollars  in thousands)**        |   | **Cost**      |       | **Gains** |   | **Losses** |   | **Value** |   |
| Maturing within  1 year            |   | $             | 15,478     |   | $ | 272 |   | $ | — |   | $ | 15,750 |   |
| After 1 year but  within 5 years   |   | 99,798        |       | 2,093 |   | (11 | ) | 101,880 |   |
| After 5 years  but within 10 years |   | 25,743        |       | 7 |   | (16 | ) | 25,734 |   |
| After 10 years                     |   | 20,301        |       | — |   | — |   | 20,301 |   |
| Total                              |   | $             | 161,320    |   | $ | 2,372 |   | $ | (27 | ) | $ | 163,665 |   |
|                               |   |          |       |   |   |   |   |   |   |
|                               |   |          |       |   |   |   |   |   |   |
|                               |   | **2001**      | ** ** |
|                               |   | **Amortized** | ** ** | **Gross Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)**         |   | **Cost**      | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Maturing within  1 year            |   | $             | 432        |   | $ | 1 |   | $ | (1 | ) | $ | 432 |   |
| After 1 year but  within 5 years   |   | 20,595        |       | — |   | (148 | ) | 20,447 |   |
| After 5 years  but within 10 years |   | 8,429         |       | 7 |   | (94 | ) | 8,342 |   |
| After 10 years                     |   | 4,965         |       | 9 |   | (48 | ) | 4,926 |   |
| Total                              |   | $             | 34,421     |   | $ | 17 |   | $ | (291 | ) | $ | 34,147 |   |

 

 

Investment securities available-for-sale that werepledged to secure short-term borrowings at December 31, 2002 and 2001 had fairvalues of $20.0 million and $1.3 million, respectively.  At December 31, 2002 and 2001, investmentsecurities available-for-sale that were pledged to secure repurchase agreementswere $0 and $507,000, respectively. Investment securities available-for-sale that were pledged to securedebtor in possession deposit accounts and treasury, tax and loan payments atDecember 31, 2002 and 2001 were $2.5 million and $249,000, respectively.

 

Other investments atDecember 31, 2002 include $933,000 of Federal Reserve Bank stock, $619,000 ofFederal Home Loan Bank stock, and $63,000 of Community Bankers’ Bank stock. Asmembers of the Federal Reserve Bank of Richmond and Federal Home Loan Bank ofAtlanta, the Company’s banking subsidiaries are required to hold stock in theseentities. Stock membership in Community Bankers’ Bank allows the Company toparticipate in loan purchases or sales including participations.  These investments are carried at cost sinceno active trading markets exist.

 

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(4)           LoansReceivable

 

The loan portfolio at December 31, 2002 and 2001consists of the following:

 
| **(Dollars in  thousands)**   |   | **2002** |    | **2001** |   |
|-------------------------------|--------|----------|---------|----------|--------|
| Commercial                    |   | $        | 58,292  |     | $      | 57,665 |   |
| Real estate - commercial      |   | 116,135  |    | 87,116   |   |
| Real estate - construction    |   | 5,781    |    | 6,397    |   |
| Real estate - residential     |   | 31,808   |    | 14,469   |   |
| Home equity lines             |   | 26,831   |    | 21,299   |   |
| Consumer                      |   | 10,235   |    | 13,941   |   |
|                          |   | 249,082  |    | 200,887  |   |
| Net deferred fees             |   | 24       |    | 24       |   |
| Loans receivable, net of fees |   | 249,106  |    | 200,911  |   |
| Allowance for loan losses     |   | (3,372   | )       | (3,104   | )      |
| Loans receivable, net         |   | $        | 245,734 |     | $      | 197,807 |   |

 

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 subsidiaries limit the amount of credit extended to anysingle borrower or group of related borrowers.

 

An analysis of the change in the allowance for loanlosses follows:

 
| **(Dollars  in thousands)**                                                   |   | **2002** |   | **2001** |   | **2000** |   |
|-------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Balance, beginning of year                                                    |   | $        | 3,104  |     | $      | 1,900    |   | $ | 726 |   |
| Provision for loan losses                                                     |   | 444      |   | 1,202    |   | 753      |   |
| Transfer to bank's liability on unfunded  commitments                         |   | (74      | )      | —   |   | —   |   |
| Assumed allowance for loan losses from  acquisition of Heritage Bancorp, Inc. |   | —   |   | —   |   | 421      |   |
| Loans charged off                                                             |   | (117     | )      | —   |   | —   |   |
| Recoveries                                                                    |   | 15       |   | 2        |   | —   |   |
| Balance, end of year                                                          |   | $        | 3,372  |     | $      | 3,104    |   | $ | 1,900 |   |

 

As of December 31, 2002 and 2001, the Company hadimpaired loans of $917,000 and $361,000, respectively, which were on nonaccrualstatus.  These impairments had valuationallowances of $480,000 and $193,000 as of December 31, 2002 and 2001,respectively.  The average balance ofimpaired loans was $568,000 and $207,000 for 2002 and 2001, respectively.  The Company recorded no interest income on impaired loans.  Interest income that would have beenrecorded had these loans been performing would have been $37,000 for 2002,$17,000 for 2001 and $34,000 for 2000.

 

57

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(5)           Premisesand Equipment

 

Components of premises and equipment atDecember 31, 2002 and 2001 were as follows:

 
| **(Dollars in  thousands)**                     |   | **2002** |   | **2001** |   |
|-------------------------------------------------|--------|----------|--------|----------|--------|
| Land                                            |   | $        | 197    |     | $      | 197 |   |
| Building                                        |   | 789      |   | 789      |   |
| Furniture and  equipment                        |   | 4,304    |   | 3,834    |   |
| Leasehold  improvements                         |   | 2,351    |   | 2,161    |   |
| Total cost                                      |   | 7,641    |   | 6,981    |   |
| Less accumulated  depreciation and amortization |   | 2,699    |   | 1,904    |   |
| Premises and  equipment, net                    |   | $        | 4,942  |     | $      | 5,077 |   |

 

Depreciation expense for the years ended December 31,2002, 2001 and 2000 was $736,000, $804,000 and $601,000, respectively.

 

The Company has entered into leases for office spaceover various terms.  The leases aresubject to annual increases as well as allocations of real estate taxes andcertain operating expenses.

 

Minimum future rental payments under the noncancelableoperating leases, as of December 31, 2002 for each of the next five yearsand in the aggregate, are as follows:

 

(Dollars in thousands)

 
| **Year ending December  31,** |   | **Amount** |   |
|-------------------------------|--------|------------|--------|
| 2003                          |   | $          | 1,273  |   |
| 2004                          |   | 997        |   |
| 2005                          |   | 1,027      |   |
| 2006                          |   | 958        |   |
| 2007                          |   | 942        |   |
| Thereafter                    |   | 1,556      |   |
|                          |   | $          | 6,753  |   |

 

The total rent expense was $1.3 million, $1.3 millionand $965,000 in 2002, 2001 and 2000, respectively.

 

In 2002 and 2001, the Company entered into contractsas sublessor for excess office space. Future minimum lease payment receivables under noncancellable leasingarrangements as of December 31, 2002 for each of the next five years and in theaggregate are as follows:

 

58

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(Dollars in thousands)

 
| **Year ending December  31,** |   | **Amount** |   |
|-------------------------------|--------|------------|--------|
| 2003                          |   | $          | 355    |   |
| 2004                          |   | 277        |   |
| 2005                          |   | 241        |   |
| 2006                          |   | 245        |   |
| 2007                          |   | 181        |   |
| Thereafter                    |   | 713        |   |
|                          |   | $          | 2,012  |   |

 

The total rent income was $409,000, $110,000 and $0 in2002, 2001 and 2000, respectively.

 

 

(6)           Deposits

 

Deposits consist of the following at December 31,2002 and 2001:

 
| **(Dollars in  thousands)**         |   | **2002** |    | **2001** |   |
|-------------------------------------|--------|----------|---------|----------|--------|
| Demand deposits                     |   | $        | 72,962  |     | $      | 61,739 |   |
| Interest checking                   |   | 146,041  |    | 45,313   |   |
| Money market and  statement savings |   | 31,078   |    | 28,676   |   |
| Certificates of  deposit            |   | 173,398  |    | 110,296  |   |
|                                |   | $        | 423,479 |     | $      | 246,024 |   |

 

Interest expense by deposit categories is as follows:

 
| **(Dollars in  thousands)**        |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Interest checking                  |   | $        | 3,073  |     | $      | 370      |   | $ | 130 |   |
| Money market and statement savings |   | 577      |   | 869      |   | 685      |   |
| Certificates of deposit            |   | 5,714    |   | 5,788    |   | 3,478    |   |
|                               |   | $        | 9,364  |     | $      | 7,027    |   | $ | 4,293 |   |

 

The aggregate amount of time deposits, each with aminimum denomination of $100,000 was $80.0 million and $59.8 million atDecember 31, 2002 and 2001, respectively.

 

At December 31, 2002, the scheduled maturities ofcertificates of deposit are as follows:

 
| **(Dollars in  thousands)** |   |   |    |
|-----------------------------|--------|--------|---------|
| 2003                        |   | $      | 68,398  |   |
| 2004                        |   | 60,405 |    |
| 2005                        |   | 14,961 |    |
| 2006                        |   | 11,893 |    |
| 2007 and thereafter         |   | 17,741 |    |
|                        |   | $      | 173,398 |   |

 

59

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(7)           OtherBorrowed Funds

 

The Company has advances from the Federal Home LoanBank of Atlanta of $2.0 million and $9.8 million at December 31, 2002 and 2001,respectively.  As of December 31,2002, 2001 and 2000, the Company had the following advances outstanding:

 

(Dollars in thousands)

 
| **As of December 31,  2002  Advance Date** |   | **Interest  Rate** |   | **Term  of Advance** |   | **Date  Due** |   | **Amount  Outstanding** |   |
|--------------------------------------------|--------|--------------------|--------|----------------------|--------|---------------|--------|-------------------------|--------|
| 9/19/01                                    |   | 3.70               | %      | 24 months            |   | 9/19/03       |   | $                       | 1,000  |   |
| 10/11/02                                   |   | 1.96               | %      | 6 months             |   | 4/11/03       |   | 1,000                   |   |
|                                       |   | 2.83               | %      |                 |   |          |   | $                       | 2,000  |   |

 
| **As of December 31,  2001  Advance Date** |   | **Interest  Rate** |   | **Term  of Advance** |   | **Date  Due** |   | **Amount    Outstanding** |   |
|--------------------------------------------|--------|--------------------|--------|----------------------|--------|---------------|--------|---------------------------|--------|
| 3/19/01                                    |   | 4.68               | %      | 12 months            |   | 3/19/02       |   | $                         | 1,800  |   |
| 3/19/01                                    |   | 4.68               | %      | 12 months            |   | 3/19/02       |   | 1,000                     |   |
| 8/6/01                                     |   | 4.05               | %      | 12 months            |   | 8/6/02        |   | 3,000                     |   |
| 8/28/01                                    |   | 3.89               | %      | 12 months            |   | 8/28/02       |   | 3,000                     |   |
| 9/19/01                                    |   | 3.70               | %      | 24 months            |   | 9/19/03       |   | 1,000                     |   |
|                                       |   | 4.15               | %      |                 |   |          |   | $                         | 9,800  |   |

 
| **As of December 31,  2000  Advance Date** |   | **Interest  Rate** |   | **Term  of Advance** |   | **Date  Due** |   | **Amount    Outstanding** |   |
|--------------------------------------------|--------|--------------------|--------|----------------------|--------|---------------|--------|---------------------------|--------|
| 12/12/00                                   |   | 6.70               | %      | 3 months             |   | 3/12/01       |   | $                         | 3,000  |   |
| 12/26/00                                   |   | 6.42               | %      | 4 months             |   | 4/26/01       |   | 3,000                     |   |
|                                       |   | 6.56               | %      |                 |   |          |   | $                         | 6,000  |   |

 

The average balances of short-term borrowings for theyears ended December 31, 2002, 2001 and 2000 were $5.6 million, $9.0 million,and $6.0 million, respectively. The maximum amount outstanding at any month-endduring the years ended December 31, 2002, 2001 and 2000 was $9.8 million, $9.8million, and $6.0 million, respectively. Total interest expense on short-term borrowings for the years endedDecember 31, 2002, 2001 and 2000 was $222,000, $448,000 and $398,000,respectively.

 

Securities sold under agreements to repurchase, whichare classified as secured borrowings, generally mature within one to four daysfrom the transaction date.  Securitiessold under agreements to repurchase are reflected at the amount of cashreceived in connection with the transaction. The Company is required to provide additional collateral based on thefair value of the underlying securities.

 

As of December 31, 2002 the Company had no repurchaseagreements.  As of December 31, 2001,and 2000, the Company had repurchase agreements of $24,000 and $1.3 million ata rate of 0.50% 

 

60

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and 5.00%, respectively.  The average balances of the repurchase agreements for 2002, 2001and 2000 were $0, $1.0 million and $929,000, respectively, and the maximum amountoutstanding at any month-end during 2001 and 2000 were $1.6 million and $3.7million, respectively.   Interestexpense on repurchase agreements for 2002, 2001 and 2000 was $0, $25,000 and$49,000, respectively.

 

(8)           PreferredStock

 

In connection with the acquisition of HeritageBancorp, Inc. on September 1, 2000, the Company issued 1,411,268 shares ofSeries A Preferred Sock, cumulative convertible.  Shares of the Preferred Stock outstanding at December 31, 2002and 2001 were 1,364,684 and 1,364,714, respectively. The Series A PreferredStock has a par value of $1.00 per share and a liquidation preference of $5.00per share.  It is redeemable by theCompany at any time on or after March 31, 2004 if the Company’s common stocktrades at a price above $8.65 for 20 consecutive days at a redemption price of$5.00 per share.  Dividends on theSeries A Preferred Stock are payable quarterly for a cumulative annual dividendof $0.3625 or 7.25% of the $5.00 liquidation amount, before any dividend ispaid on any Cardinal common stock. Holders of Series A Preferred Stock have the right to convert 1 share ofSeries A Preferred Stock for 0.75 shares of Cardinal common stock at anytime.  Holders of Series A PreferredStock are not entitled to receive notice of, or to participate in, or to voteon any matter at any meeting of the shareholders, except to the extent thatthey are afforded a vote by the laws of the Commonwealth of Virginia inexistence at the time any matter requiring such a vote shall arise.  Notwithstanding the lack of voting rights,under Sections 13.1-707 and 708 of the Virginia Stock Corporation Act theholders of the Series A Preferred Stock are entitled to notice of any meetingof the shareholders considering an amendment to our Articles of Incorporationrelating to any of the matters described in Section 13.1-708 of the VirginiaStock Corporation Act and to vote as a class.

 

(9)           IncomeTaxes

 

The Company and its subsidiaries file consolidated taxreturns on a calendar-year basis. The Company had no provision for current and deferred income taxes forthe years ended December 31, 2002, 2001 and 2000, respectively.

 

The provision for income taxes is reconciled to theamount computed by applying the federal corporate tax rate to income beforetaxes and is as follows:

 
| **(Dollars  in thousands)**                    |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Income tax (benefit) at federal corporate rate |   | $        | (180   | )        | $      | (4,326   | )      | $ | (1,350 | ) |
| Nondeductible expenses                         |   | 7        |   | 2,998    |   | 90       |   |
| Change in valuation allowance                  |   | 173      |   | 1,328    |   | 1,260    |   |
|                                           |   | $        | — |     | $      | —   |   | $ | — |   |

 

The tax benefits of temporary differences between thefinancial reporting basis and income tax basis of assets and liabilities relateto the following:

 

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| **(Dollars  in thousands)**                                 |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets:                                        |   |     |   |     |   |
| Bad debts                                                   |   | $        | 1,047  |     | $      | 910 |   |
| Organization and other costs                                |   | 19       |   | 46       |   |
| Net operating loss carryforwards                            |   | 4,401    |   | 4,482    |   |
| Unrealized (gains) losses on investments available-for-sale |   | (797     | )      | 95       |   |
| Other                                                       |   | 157      |   | 154      |   |
| Total gross deferred assets                                 |   | 4,827    |   | 5,687    |   |
| Less valuation allowance                                    |   | (4,553   | )      | (5,365   | )      |
| Net deferred tax assets                                     |   | 274      |   | 322      |   |
| Deferred tax liabilities:                                   |   |     |   |     |   |
| Prepaid expenses                                            |   | (19      | )      | (31      | )      |
| Depreciation                                                |   | (134     | )      | (154     | )      |
| Loan origination costs                                      |   | (121     | )      | (135     | )      |
| Other                                                       |   | —   |   | (2       | )      |
| Total gross deferred tax liabilities                        |   | (274     | )      | (322     | )      |
|                                                        |   |     |   |     |   |
| Net deferred tax asset                                      |   | $        | — |     | $      | — |   |

 

Deferred income taxes reflect temporary differences inthe recognition of revenue and expenses for tax reporting and financialstatement purposes, principally because certain items, such as depreciation andamortization, are recognized in different periods for financial reporting andtax return purposes.  A valuationallowance in the amount of $4.5 million at December 31, 2002 and $5.4million at December 31, 2001 has been established for deferred tax assets,as realization is dependent upon generating future taxable income.

 

The Company has net operating loss carryforwards ofapproximately $12.9 million at December 31, 2002, which are available tooffset future taxable income.  $1.9million of the net operating loss carryforwards is subject to annual limitationon utilization.  The Company’s netoperating loss carryforwards expire as follows:  $1.5 million in 2018, $3.6 million in 2019, $5.1 million in 2020,and $2.7 in 2021.

 

(10)         RegulatoryMatters

 

The Company’s banking subsidiary, Cardinal Bank, N.A.(the “Bank”), as a national bank, is subject to the dividend restrictionsestablished by the Comptroller of the Currency.  Under such restrictions, the Bank may not, without the priorapproval of the Comptroller of the Currency, declare dividends in excess of thesum of the current year’s earnings (as defined) plus the retained earnings (asdefined) from the prior two years.  AtDecember 31, 2002, there were no earnings against which dividends could bepaid.

 

The Bank is required to maintain a minimum averagereserve balance with the Federal Reserve Bank. The average amount of the required reserve was $10.2 million for2002.  As members of the Federal ReserveBank system, the Bank is required to subscribe to shares of $100 par valueFederal Reserve Bank stock equal to 6 percent of the Bank’s capital andsurplus.  The Bank is required to 

 

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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.

 

The Federal Deposit Insurance Corporation ImprovementAct of 1991 (“FDICIA”) requires the regulators to stratify institutions intofive quality tiers based upon their relative capital strengths and to increaseprogressively the degree of regulation over the weaker institutions, limits thepass through deposit insurance treatment of certain types of accounts, adopts a“truth in savings” program, calls for the adoption of risk-based premiums ondeposit insurance and requires the Bank to observe insider credit underwritingproducts no less strict than those applied to comparable noninsidertransactions.

 

At December 31, 2002 and 2001, the Company andthe Bank met all regulatory capital requirements.  The key measures of capital are: (1) total capital (Tier Icapital plus the allowance for loan losses up to certain limitations) as apercent of total risk-weighted assets, (2) Tier I capital (asdefined) as a percent of total risk-weighted assets (as defined), and(3) Tier I capital (as defined) as a percent of total assets (as defined).

 

**As of 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 | % |
|                                        |        |            |        |                                          |        |                                                                                           |        |  |  |  |  |  |  |  |  |  |  |  |

 

**As of 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  |   | $          | 23,333 |                                     | 10.42  | %                                                                                         | $      | 17,909 |   | > | 8.00 | % | $ | 22,387 |   | > | 10.00 | % |
| Tier I capital to risk weighted assets |   | 20,230     |   | 9.04                                     | %      | 8,955                                                                                     |   | > | 4.00 | % | 13,432 |   | > | 6.00 | % |
| Tier I capital to average assets       |   | 20,230     |   | 8.57                                     | %      | 10,891                                                                                    |   | > | 4.00 | % | 13,614 |   | > | 5.00 | % |
|                                        |        |            |        |                                          |        |                                                                                           |        |  |  |  |  |  |  |  |  |  |  |  |

 

(11)         Related-PartyTransactions

 

Officers, directors, employees and their relatedbusiness interests are loan customers in the ordinary course of business.  In management’s opinion, these loans aremade on substantially the same terms, including interest rates and collateral,as those prevailing at the time for comparable loans with other persons and donot involve more than normal risk of collectibility or present otherunfavorable features.

 

 

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Analysis of activity for loans to related parties isas follows:

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

 

 

(12)         Loss Per Common Share

 

The following is the calculation of basic and dilutedloss per common share.  Because theCompany has net losses, all stock options issued have an anti-dilutive effectand, therefore, have been excluded from the loss per common share calculation.

 
| **(Dollars  and shares in thousands)**        |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                          |   |     |   |     |   |     |   |
| Net loss                                      |   | $        | (529   | )        | $      | (12,724  | )      | $ | (3,971 | ) |
| Dividends to preferred shareholders           |   | 495      |   | 503      |   | 171      |   |
| Net loss to common shareholders               |   | $        | (1,024 | )        | $      | (13,227  | )      | $ | (4,142 | ) |
| Weighted average shares for basic and diluted |   | 7,949    |   | 4,258    |   | 4,246    |   |
| Basic loss per common share                   |   | $        | (0.13  | )        | $      | (3.11    | )      | $ | (0.98 | ) |
| Diluted loss per common share                 |   | $        | (0.13  | )        | $      | (3.11    | )      | $ | (0.98 | ) |

 

(13)         Employee Benefit Plan

 

The Company established a 401(k) plan inJanuary 1998 for all eligible employees. The Company began to match a portion of employee contributions beginningJanuary 1, 1999.  The Company’smatch for December 31, 2002, 2001 and 2000 was $102,000, $118,000 and $109,000,respectively.

 

(14)         Director and EmployeeStock Compensation Plans

 

In 1998, the Company adopted a stock option plan(the ”Plan”) pursuant to which the Company may grant stock options toemployees and members of the Company’s and its’ subsidiaries’ Boards ofDirectors.  The Company has grantedoptions to purchase up to 625,000 shares of common stock as ofDecember 31, 2002.

 

In 1999, the Company granted stock awards to anemployee.  These awards became fullyvested in 2001. For the years ended December 31, 2002, 2001 and 2000, theCompany recognized $0, $6,000 and $12,000, respectively, in compensationexpense related to the stock awards.

 

Stock options are granted with an exercise price equalto the stock’s fair market value at the date of grant.  Director stock options have 10-yearterms and vest and become fully 

 

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exercisableafter 3 years. Other employee stock options have 10-year terms and vest andbecome fully exercisable in 20% increments beginning after their first year ofvesting.

 

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   |   |

 

AtDecember 31, 2002, the range of exercise prices and weighted-averageremaining contractual life of outstanding options were $2.41 – $10.00 and 8.0years, respectively.  At December 31,2001, the range of exercise prices and weighted-average remaining contractuallife of outstanding options were $2.41 - $10.00 and 7.7 years,respectively.  As of December 31, 2002and 2001, the outstanding options exercisable were 279,634 and 171,793,respectively.  The weighted averageexercise price for the outstanding options exercisable as of December 31, 2002and 2001 are $4.71 and $4.48, respectively.

 

Informationpertaining to options outstanding at December 31, 2002 is as follows:

 
|                          |   | **Options  Outstanding** |   | **Options  Exercisable**        |   |
|-------------------------------|--------|--------------------------|--------|---------------------------------|--------|
|                          |   |                     |   | **Weighed  Average**            |   |   |   | **Weighted  Average** |   |
| **Range of  Exercise Prices** |   | **Number  Outstanding**  |   | **Remaining  Contractual Life** |   | **Exercise  Prices** |   | **Number  Exercisable** |   | **Exercise  Price** |   |
|                          |   |                     |   |                            |   |   |   |   |   | Exercise |   |
| $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 |   |

 

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At December 31, 2002and 2001, additional shares available for grant under the Plan were 72,039 and246,904, respectively.  The per shareweighted-average fair value of stock options granted during 2002 and 2001was $2.12 and $2.04, respectively, on the date of grant using the Black Scholesoption-pricing model (using an expected volatility over the expected life ofthe options of 20.4 percent and 36.3 percent, respectively).  As of December 31, 2002 the weighted-averageassumptions were as follows: expected dividend yield 0.00 percent, risk-freeinterest rate of 4.25 percent, and an expected life of 10 years.  As of December 31, 2001, theweighted-average assumptions were as follows: expected dividend yield0.00 percent, risk-free interest rate of 4.90 percent, and anexpected life of 10 years.

 

TheCompany applies APB Opinion No. 25 in accounting for its Plan and,accordingly, no compensation cost has been recognized for its stockoptions.  Had the Company determinedcompensation cost based on the fair value at the grant date for its stockoptions under SFAS No. 123, the Company’s net loss would have been increasedto the pro forma amounts indicated below:

 
| **(Dollars in thousands)**       |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net loss to common shareholders: |   |     |   |     |   |     |   |
| As reported                      |   | $        | (1,024 | )        | $      | (13,227  | )      | $ | (4,142 | ) |
| Pro forma                        |   | (1,289   | )      | (13,365  | )      | (4,262   | )      |
| Loss per common share:           |   |     |   |     |   |     |   |
| As reported                      |   | $        | (0.13  | )        | $      | (3.11    | )      | $ | (0.98 | ) |
| Pro forma                        |   | (0.16    | )      | (3.14    | )      | (1.00    | )      |

 

During 2002, theshareholders approved the Company’s 2002 Equity Compensation Plan.  The Equity Plan authorizes the granting ofoptions, which may either be Incentive Stock Options, Non-Qualified StockOptions, stock appreciation rights, restricted stock awards, phantom stockawards and performance share awards to directors, eligible officers and keyemployees of the Company.  The EquityPlan authorizes the issuance of options and other equity instruments equivalentto 700,000 shares, or 6.32% of the outstanding shares of common stock plusshares of common stock issuable upon conversion of the Company’s outstandingSeries A Preferred Stock.  No shareswere granted under the 2002 Equity Compensation Plan as of December 31, 2002.

 

(15)         Segment Reporting

 

TheCompany operates and reports in two business segments, commercial banking andinvestment advisory services.  Thecommercial banking segment includes both commercial and consumer lending andprovides customers such products as commercial loans, real estate loans, andother business financing and consumer loans. In addition, this segment also provides customers with several choicesof deposit products including demand deposit accounts, savings accounts andcertificates of deposit.  The investmentadvisory services segment provides advisory services to businesses andindividuals including financial planning and retirement/estate planning.

 

Informationabout reportable segments, and reconciliation of such information to the consolidatedfinancial statements as of and for the years ended December 31, 2002, 2001 and2000 follows:

 

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|                       |   | **December  31, 2002**  |    |
|----------------------------|--------|-------------------------|---------|
| **(Dollars in thousands)** |   | **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       |   | 2,122                   |    | 942 |   | 209 |   | — |   | 3,273 |   |
| Non-interest  expense      |   | 12,269                  |    | 1,147 |   | 598 |   | — |   | 14,014 |   |
| Net  loss                  |   | $                       | (16     | ) | $ | (205 | ) | $ | (308 | ) | $ | — |   | $ | (529 | ) |
|                       |   |                    |    |   |   |   |   |   |   |   |   |
| Total  assets              |   | $                       | 483,135 |   | $ | 274 |   | $ | 41,159 |   | $ | (38,245 | ) | $ | 486,323 |   |

 
|                       |   | **December  31, 2002**  |    |
|----------------------------|--------|-------------------------|---------|
|                       |   | **Commercial  Banking** |    | **Investment  Advisory** |   | **Other** |   | **Intersegment  Elimination** |   | **Consolidated** |   |
| Net  interest income       |   | $                       | 9,051   |   | $ | — |   | $ | 26 |   | $ | — |   | $ | 9,077 |   |
| Provision  for loan losses |   | 1,202                   |    | — |   | — |   | — |   | 1,202 |   |
| Non-interest  income       |   | 1,210                   |    | 1,947 |   | 116 |   | — |   | 3,267 |   |
| Non-interest  expense      |   | 19,220                  |    | 2,034 |   | 2,612 |   | — |   | 23,866 |   |
| Net loss                   |   | $                       | (10,161 | ) | $ | (87 | ) | $ | (2,470 | ) | $ | — |   | $ | (12,724 | ) |
|                       |   |                    |    |   |   |   |   |   |   |   |   |
| Total  assets              |   | $                       | 277,930 |   | $ | 420 |   | $ | 23,228 |   | $ | (21,994 | ) | $ | 279,584 |   |

 
|                       |   | **December  31, 2002**  |    |
|----------------------------|--------|-------------------------|---------|
|                       |   | **Commercial  Banking** |    | **Investment  Advisory** |   | **Other** |   | **Intersegment  Elimination** |   | **Consolidated** |   |
| Net  interest income       |   | $                       | 5,914   |   | $ | — |   | $ | 496 |   | $ | — |   | $ | 6,410 |   |
| Provision  for loan losses |   | 753                     |    | — |   | — |   | — |   | 753 |   |
| Non-interest  income       |   | 574                     |    | 1,515 |   | 13 |   | (4 | ) | 2,098 |   |
| Non-interest  expense      |   | 6,695                   |    | 1,990 |   | 3,045 |   | (4 | ) | 11,726 |   |
| Net  loss                  |   | $                       | (960    | ) | $ | (475 | ) | $ | (2,536 | ) | $ | — |   | $ | (3,971 | ) |
|                       |   |                    |    |   |   |   |   |   |   |   |   |
| Total  assets              |   | $                       | 193,641 |   | $ | 176 |   | $ | 35,014 |   | $ | (21,783 | ) | $ | 207,048 |   |

 

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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-sheetrisk in the normal course of business to meet the financing needs of itscustomers.  These financial instrumentsinclude commitments to extend credit and standby letters of credit andfinancial guarantees.  Commitments toextend credit are agreements to lend to a customer so long as there is noviolation of any condition established in the contract.  Commitments usually have fixed expirationdates up to one year or other termination clauses and may require payment of afee.  Since many of the commitments areexpected to expire without being drawn upon, the total commitment amounts donot necessarily represent future 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, 2002 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, 2002 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)**                                                     |   | **2002** |   | **2001** |   |
|--------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Financial instruments  whose contract amounts represent potential credit risk: |   |     |   |     |   |
| Commitments to extend credit                                                   |   | $        | 66,767 |     | $      | 56,382 |   |
| Standby letters of credit                                                      |   | 1,610    |   | 3,168    |   |
|                                                                                |        |          |        |          |        |  |  |

 

The Company had recorded no liabilityassociated with standby letters of credit at December 31, 2002.

 

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 tosupport financial instruments when deemed necessary.  The amount of collateral obtained upon extension of credit isbased on management’s evaluation of the counterparty.  Collateral held varies but may include deposits held by theCompany, marketable securities, accounts receivable, inventory, property, plantand equipment, and income-producing commercial properties.

 

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(17)         Disclosures of Fair Value of FinancialInstruments

 

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 or verificationand may change as economic and market factors, and management’s evaluation ofthose 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 Valueof Financial Instruments*

 

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

 

*Cash and Cash Equivalents*

 

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

 

*Investment Securities 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 as their cost since noactive trading markets exist.

 

*Loans Heldfor Sale*

 

Loansheld for sale are valued based on quoted market prices from secondary marketinvestors with commitments to purchase the loans.

 

*Loans Receivable*

 

Inorder to determine the fair market value for loans receivable, the loanportfolio was 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 amounts ofvariable

 

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rate,fixed-term money market accounts and certificates of deposit (CDs) approximatetheir fair value at the reporting date. Fair values for fixed-rate CDs are estimated using a discountedcash flow calculation that applies interest rates currently being offered oncertificates to a schedule of aggregated expected monthly maturities on timedeposits.

 

*Other Borrowed Funds*

 

Thefair value of borrowings is estimated using a discounted cash flow calculationthat applies an interest rate currently available 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 reasonable estimatesof the fair value of these financial instruments.  The carrying amounts of these instruments are zero atDecember 31, 2002 and 2001.

 

*Accrued Interest*

 

Thecarrying amounts of accrued interest approximate their fair values.

 

Fairvalue of financial instruments as of December 31, 2002 and 2001:

 
|                                        |   | **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                            |   | 249,106               |   | 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 |   |

 

70

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|                                        |   | **December 31, 2001** |   |
|---------------------------------------------|--------|-----------------------|--------|
| **(Dollars in thousands)**                  |   | **Carrying  Amount**  |   | **Estimated  Fair Value** |   |
|                                        |   |                  |   |   |   |
| Financial assets:                           |   |                  |   |   |   |
| Cash and cash equivalents                   |   | $                     | 34,459 |   | $ | 34,459 |   |
| Investment securities and other investments |   | 35,415                |   | 35,415 |   |
| Loans held for sale                         |   | 4,732                 |   | 4,760 |   |
| Loans receivable                            |   | 200,911               |   | 200,143 |   |
| Accrued interest receivable                 |   | 1,090                 |   | 1,090 |   |
| Financial liabilities:                      |   |                  |   |   |   |
| Demand deposits                             |   | $                     | 61,739 |   | $ | 61,739 |   |
| Interest checking                           |   | 45,313                |   | 45,313 |   |
| Money market and statement savings          |   | 28,676                |   | 28,676 |   |
| Certificates of deposit                     |   | 110,296               |   | 114,629 |   |
| Other borrowed funds                        |   | 9,824                 |   | 9,824 |   |
| Accrued interest payable                    |   | 12                    |   | 12 |   |

 

(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, 2002 and 2001

 

(Dollars in thousands)

 
|                                             |   | **2002** |   | **2001** |   |
|--------------------------------------------------|--------|----------|--------|----------|--------|
| **Assets**                                       |   |     |   |     |   |
| Cash  and cash equivalents                       |   | $        | 5,989  |     | $      | 2,584 |   |
| Other  investments                               |   | 63       |   | 67       |   |
| Investment  in subsidiaries                      |   | 32,472   |   | 17,799   |   |
| Premises  and equipment, net                     |   | 1,825    |   | 1,986    |   |
| Goodwill  and other intangibles, net             |   | 646      |   | 668      |   |
| Other  assets                                    |   | 164      |   | 124      |   |
|                                             |   |     |   |     |   |
| Total  assets                                    |   | $        | 41,159 |     | $      | 23,228 |   |
|                                             |   |     |   |     |   |
| **Liabilities and Shareholders’ Equity**    |   |     |   |     |   |
| Total  liabilities                               |   | $        | 447    |     | $      | 2,604 |   |
| Total  shareholders’ equity                 |   | $        | 40,712 |     | $      | 20,624 |   |
|                                             |   |     |   |     |   |
| Total  liabilities and shareholders’ equity |   | $        | 41,159 |     | $      | 23,228 |   |

 

71

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PARENT COMPANY ONLY CONDENSED STATEMENTS OF OPERATIONS

Years Ended December 31, 2002, 2001 and 2000

(Dollars in thousands)

 
|                                                                               |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                               |   |     |   |     |   |     |   |
| Income:                                                                            |   |     |   |     |   |     |   |
| Interest  income                                                                   |   | $        | 81     |     | $      | 26       |   | $ | 496 |   |
| Other  income                                                                      |   | 209      |   | 116      |   | 13       |   |
|                                                                               |   |     |   |     |   |     |   |
| Total  income                                                                      |   | 290      |   | 142      |   | 509      |   |
|                                                                               |   |     |   |     |   |     |   |
| Expense  - General and administrative                                              |   | 598      |   | 2,612    |   | 3,045    |   |
|                                                                               |   |     |   |     |   |     |   |
| Net  loss before income taxes and equity in undistributed earnings of subsidiaries |   | (308     | )      | (2,470   | )      | (2,536   | )      |
|                                                                               |   |     |   |     |   |     |   |
| Provision  for income taxes                                                        |   | —   |   | —   |   | —   |   |
|                                                                               |   |     |   |     |   |     |   |
| Equity in undistributed earnings of subsidiaries                                   |   | (221     | )      | (10,254  | )      | (1,435   | )      |
|                                                                               |   |     |   |     |   |     |   |
| Net loss                                                                           |   | $        | (529   | )        | $      | (12,724  | )      | $ | (3,971 | ) |

 

72

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PARENTCOMPANY ONLY CONDENSED STATEMENTS OF CASH FLOWS

 

Years ended December 31, 2002,2001 and 2000

 

(Dollars in thousands)

 
|                                                                                       |   | **2002** |   | **2001** |       | **2000**   |       |
|--------------------------------------------------------------------------------------------|--------|----------|--------|----------|------------|------------|------------|
|                                                                                       |   |     |   |     |       |       |       |
| Cash flows from operating activities:                                                      |   |     |   |     |       |       |       |
| Net loss                                                                                   |   | $        | (529   | )        | $          | (12,724    | )          | $ | (3,971 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |   |     |   |     |       |       |       |
| Equity in undistributed earnings of subsidiaries                                           |   | 221      |   | 1,984    |       | 1,435      |       |
| Depreciation and amortization and write down of goodwill                                   |   | 238      |   | 9,129    |       | 465        |       |
| Increase in other assets and liabilities                                                   |   | (2,413   | )      | 1,754    |       | 543        |       |
|                                                                                       |   |     |   |     |       |       |       |
| Net cash provided by (used in) operating activities                                        |   | (2,483   | )      | 143      |       | (1,528     | )          |
|                                                                                       |   |     |   |     |       |       |       |
| Cash flows from investing activities:                                                      |   |     |   |     |       |       |       |
| Capital infusions in subsidiaries                                                          |   | (12,275  | )      | (720     | )          | (750       | )          |
| Dividends from subsidiary                                                                  |   | —   |   | —   |       | 3,000      |       |
| Net change in premises and equipment                                                       |   | 161      |   | 158      |       | (62        | )          |
| Proceeds from sale and redemptions of securities                                           |   | —   |   | —   |       | 2,468      |       |
| Proceeds from sale of other investments                                                    |   | 4        |   | 17       | ** ** | **—** | ** ** |
| Cash paid in acquisition                                                                   |   | —   |   | —   |       | (7,726     | )          |
|                                                                                       |   |     |   |     |       |       |       |
| Net cash used in investing activities                                                      |   | (12,110  | )      | (545     | )          | (3,070     | )          |
|                                                                                       |   |     |   |     |       |       |       |
| Cash flows from financing activities:                                                      |   |     |   |     |       |       |       |
| Proceeds from rights and secondary offerings                                               |   | 18,493   |   | —   |       | —     |       |
| Dividends declared on preferred stock                                                      |   | (495     | )      | (503     | )          | (170       | )          |
| Stock options exercised                                                                    |   | —   |   | 11       |       | 22         |       |
|                                                                                       |   |     |   |     |       |       |       |
| Net cash provided by (used in) financing activities                                        |   | 17,998   |   | (492     | )          | (148       | )          |
|                                                                                       |   |     |   |     |       |       |       |
| Net increase (decrease) in cash and cash equivalents                                       |   | 3,405    |   | (894     | )          | (4,746     | )          |
|                                                                                       |   |     |   |     |       |       |       |
| Cash and cash equivalents at beginning of year                                             |   | 2,584    |   | 3,478    |       | 8,224      |       |
|                                                                                       |   |     |   |     |       |       |       |
| Cash and cash equivalents at end of year                                                   |   | $        | 5,989  |     | $          | 2,584      |       | $ | 3,478 |   |

 

(19)         Goodwill and OtherIntangible Assets

 

**AtDecember 31, 2002, goodwill of $646,000 represents the remaining balanceattributable to the purchase of Heritage Bancorp, Inc.  In 2001, the Company substantiallyeliminated the goodwill**

** **

73

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**attributablefrom this acquisition.  The initialinvestment in Heritage, which was subsequently, renamed Cardinal Bank —Potomac, resulted in the Company recording $9.7 million of goodwill at the timeof the acquisition.  In the fourthquarter of 2001, an evaluation of current year losses and expectations ofadditional future losses indicated a potential impairment in the Company’sinvestment in Heritage.  In compliancewith SFAS No. 121, the Company wrote down goodwill by $8.3 million based upon avaluation obtained from an independent third party consultant.**

 

**TheCompany adopted SFAS No. 142 as of January 1, 2002, and, therefore,discontinued the amortization of goodwill on January 1, 2002, which had theeffect of decreasing the Company’s net loss by $35,000.  The Company has evaluated impairment ofgoodwill under SFAS No. 142. The evaluation of goodwill under this statementdid not result in impairment of the Company’s goodwill as of the annualevaluation date.  Information on theCompany’s intangible assets is contained in the table below.**

 

74

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|                                |   | **December 31, 2002**     |   | **December 31, 2001**         |   |
|-------------------------------------|--------|---------------------------|--------|-------------------------------|--------|
| **(Dollars in thousands)**          |   | **Gross  Carrying Value** |   | **Accumulated  Amortization** |   | **Gross   Carrying Value** |   | **Accumulated  Amortization** |   |
| Amortizable core deposit intangible |   | $                         | 102    |                          | $      | (102 | ) | $ | 102 |   |  $(80 | ) |
| Unamortizable goodwill              |   | 646                       |   | —                        |   | 646 |   | — |   |
|                                     |        |                           |        |                               |        |  |  |  |  |  |  |  |

 
| **Amortization expense:**              |   | **Core Deposit  Intangible** |   | **Goodwill** |   |
|----------------------------------------|--------|------------------------------|--------|--------------|--------|
| Twelve months ended December  31, 2002 |   | 22                           |   |         |   |
| Twelve months ended December  31, 2001 |   | 60                           |   | 8,847        | (1)    |

 
|                                              |   | **December 31,** |   |
|---------------------------------------------------|--------|------------------|--------|
|                                              |   | **2002**         |   | **2001** |   | **2000** |   |
| Reported net loss to common  shareholders         |   | $                | (1,024 | ) | $ | (13,227 | ) | $ | (4,142 |   |
| Add: goodwill amortization                        |   | —           |   | 8,847 |   | 215 |   |
| Adjusted net loss                                 |   | (1,024           | )      | (4,380 | ) | (3,927 | ) |
|                                              |   |             |   |   |   |   |   |
| Reported basic and diluted loss  per common share |   | $                | (0.13  | ) | $ | (3.11 | ) | $ | (0.98 | ) |
| Add: goodwill amortization per  common share      |   | —           |   | 2.08 |   | 0.05 |   |
| Adjusted basic and diluted loss  per common share |   | $                | (0.13  | ) | $ | (1.03 | ) | $ | (0.93 | ) |

 

----

(1) In December 2001, the Company wrote downgoodwill by $8.3 million.

 

As of December 31, 2002, the Company’s core depositintangible was fully amortized thus; there is no more amortization expenseafter December 31, 2002.

 

(20)         Restructuring Costs

 

**In2001, the Company announced plans to restructure and merge all of its bankingsubsidiaries into one central lead bank under the holding company.  This decision was made in order to reducethe costs associated with operating multiple banking subsidiaries.  In connection with the restructuring, theCompany recorded $884,000 of restructuring costs.   Included in the total were severance and other employee relatedcosts including contract buyouts, write-downs of leasehold improvementsassociated with the subleasing of redundant property, liabilities recordedrelated to the subleased property, and merger costs related to data processingconversions with outside vendors. The following table rolls forward the amountsfrom the prior year.**

 
| **(Dollars in thousands)**                          |   | **Liability at  December 31,  2001** |   | **Expenses  Paid or  Assets  Written Off  in 2002** |   | **Liability at  December 31,  2002** |   |
|-----------------------------------------------------|--------|--------------------------------------|--------|-----------------------------------------------------|--------|--------------------------------------|--------|
| Employee termination benefits  and contract buyouts |   | $                                    | 395    |                                                | $      | 395                                  |   | $ | — |   |
| Leasehold write-downs                               |   | 251                                  |   | 251                                                 |   | —                               |   |
| Merger expenses                                     |   | 165                                  |   | 165                                                 |   | —                               |   |
| Sublease liability                                  |   | 73                                   |   | 11                                                  |   | 62                                   |   |
|                                                |   | $                                    | 884    |                                                | $      | 822                                  |   | $ | 62 |   |

 

75

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(21)         Other OperatingExpenses

 

**Thefollowing shows the composition of operating expenses for the years endedDecember 31, 2002, 2001 and 2000:**

 
| **(Dollars in thousands)** |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------|--------|----------|--------|----------|--------|----------|--------|
| Data processing            |   | $        | 759    |     | $      | 957      |   | $ | 561 |   |
| Stationery and supplies    |   | 317      |   | 306      |   | 345      |   |
| Brokerage clearing         |   | 206      |   | 370      |   | 345      |   |
| Advertising and marketing  |   | 541      |   | 368      |   | 241      |   |
| Telecommunications         |   | 276      |   | 325      |   | 254      |   |
| Other taxes                |   | 342      |   | 269      |   | 221      |   |
| Travel and entertainment   |   | 127      |   | 164      |   | 139      |   |
| Bank operations            |   | 411      |   | 875      |   | 165      |   |
| Premises and equipment     |   | 271      |   | 247      |   | 142      |   |
| Miscellaneous              |   | 239      |   | 465      |   | 577      |   |
| Total operating expense    |   | $        | 3,489  |     | $      | 4,346    |   | $ | 2,990 |   |

 

76

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**Item8.                   Changes in andDisagreements with Accountants on Accounting and Financial Disclosure**

 

No changes in theCompany’s independent accountants or disagreements on accounting and financialdisclosure required to be reported hereunder have taken place.

#####  

##### **PART III**

 

**Item 9.                   Directors, Executive Officers, Promoters and Control Persons; Compliancewith Section 16(a) of**

**                               theExchange Act**

 

                Pursuant toGeneral Instruction E(3) of Form 10-KSB, the information contained in the “TheBoard of Directors” section and under the headings “Executive Officers” and“Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’sProxy Statement for the 2003 Annual Meeting of Shareholders is incorporatedherein by reference.

 

**Item10.                Executive Compensation**

 

                Pursuant toGeneral Instruction E(3) of Form 10-KSB, the information contained under theheadings “Director Compensation,” “Executive Compensation,” “Stock Options,”and “Employment Agreements” in the Company’s Proxy Statement for the 2003Annual Meeting of Shareholders is incorporated herein by reference.

 

**Item 11.                Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters**

 

*SecurityOwnership of Certain Beneficial Owners and Management.*  Pursuant to General Instruction E(3) of Form10-KSB, the information contained under the headings “Security Ownership ofDirectors and Executive Officers” and “Security Ownership of Certain BeneficialOwners” in the Company’s Proxy Statement for the 2003 Annual Meeting ofShareholders is incorporated herein by reference.

 

*EquityCompensation Plan Information.*  The following table sets forth information as of December 31,2002, with respect to compensation plans under which shares of our Common Stockare authorized for issuance.

 

77

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| **Plan  Category**                                         |   | **Number of  Securities to Be  Issued upon Exercise of   Outstanding Options,  Warrants and Rights** |   | **Weighted  Average  Exercise Price of  Outstanding Options,   Warrants and Rights** |   | **Number of  Securities  Remaining Available  for Future Issuance  Under Equity  Compensation Plans(1)** |    |
|------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|---------|
|                                                       |   |                                                                                                 |   |                                                                                 |   |                                                                                                     |    |
| Equity  Compensation Plans Approved by Shareholders        |   |                                                                                                 |   |                                                                                 |   |                                                                                                     |    |
| 1999 Stock Plan                                            |   | 542,893                                                                                              |   | $                                                                                    | 4.22   |                                                                                                     | 72,039  |   |
| 2002 Equity  Compensation Plan                             |   | —                                                                                               |   | —                                                                               |   | 700,000                                                                                                  |    |
| Equity  Compensation Plans Not Approved by Shareholders(2) |   | —                                                                                               |   | —                                                                               |   | —                                                                                                   |    |
|                                                       |   |                                                                                                 |   |                                                                                 |   |                                                                                                     |    |
| Total                                                      |   | 542,893                                                                                              |   | $                                                                                    | 4.22   |                                                                                                     | 772,039 |   |

 

----

(1)  Amounts exclude any securities to be issuedupon exercise of outstanding options, warrants and rights.

 

(2)  The Company does not have any equitycompensation plans that have not been approved by shareholders.

 

**Item 12.                 Certain Relationships andRelated Transactions**

 

                Pursuant to General InstructionE(3) of Form 10-KSB, the information contained under the heading “Transactionswith Management” in the Company’s Proxy Statement for the 2003 Annual Meetingof Shareholders is incorporated herein by reference.

 

**Item13****.                 Exhibits, List and Reports onForm 8-K**

 
| (a)    | Exhibits | .      |                                                                                                                                                                                                                     |
|--------|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |     |   |                                                                                                                                                                                                                     |   |
|   | 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      |   | Amended Bylaws of Cardinal Financial Corporation  (incorporated by reference to Exhibit 3.3 to the Quarterly Report on Form  10-QSB for the period ended June 30, 2002).                                                 |   |
|   |     |   |                                                                                                                                                                                                                     |   |
|   | 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.                                                                                                                                                                          |   |
|   |     |   |                                                                                                                                                                                                                     |   |
|   | 99.1     |   | Statement of Chief Executive Officer Pursuant to 18  U.S.C. § 1350.                                                                                                                                                 |   |
|   |     |   |                                                                                                                                                                                                                     |   |
|   | 99.2     |   | Statement of Chief Financial Officer Pursuant to 18  U.S.C. § 1350.                                                                                                                                                 |   |
|   |     |   |                                                                                                                                                                                                                     |   |

 

78

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|   | (b)    | Reports on Form 8-K                                                                                                                                                                                                                     |   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   |   |                                                                                                                                                                                                                                    |   |
|   |   | On December 10, 2002, the Company filed a Current  Report on Form 8-K dated December 10, 2002 to report under Item 5, and to  include as an exhibit a press release on, the resignation of the Company’s  Chief Financial Officer. |   |

 

**Item 14. Controls and Procedures**

 

The Company maintainsdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed by it in the reports that it files or submits underthe Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods required by the Securities andExchange Commission, including, without limitation, those controls andprocedures designed to ensure that such information is accumulated and communicatedto the Company’s management to allow timely decisions regarding requireddisclosures.

 

Within the 90 day periodprior to the filing of this report, an evaluation of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures wascarried out under the supervision and with the participation of the Company’smanagement, including the chief executive officer and chief financialofficer.  Based on and as of the date ofsuch evaluation, these officers concluded that the Company’s disclosurecontrols and procedures were effective.

 

The Company alsomaintains a system of internal accounting controls that is designed to provideassurance that assets are safeguarded and that transactions are executed inaccordance with management’s authorization and properly recorded.  This system is continually reviewed and isaugmented by written policies and procedures, the careful selection andtraining of qualified personnel and an internal audit program to monitor itseffectiveness.  There have been nosignificant changes to this system of internal controls or in other factorsthat could significantly affect those controls subsequent to the date of theCompany’s evaluation.

 

79

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**SIGNATURES**

 

In accordance withSection 13 and 15(d) of the Securities and 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 28, 2003.

 

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

 

In accordance with theSecurities and Exchange Act of 1934, this report has been filed below by thefollowing persons in the capacities indicated on March 28, 2003.

 
| **Signatures** |                              |   | **Title**                                            |
|----------------|-----------------------------------|--------|------------------------------------------------------|
|           |                              |   |                                                 |
| /s/            | Bernard H. Clineburg              |   | Chairman, President and Chief Executive Officer      |
|           | Name:   Bernard H. Clineburg |   | (Principal Executive Officer)                        |
|           |                              |   |                                                 |
| /s/            | Carl E. Dodson                    |   | Executive Vice President and Chief Financial Officer |
|           | Name:  Carl  E. Dodson       |   | (Principal Financial Officer)                        |
|           |                              |   |                                                 |
| /s/            | Jennifer L. Deacon                |   | Vice President and Controller                        |
|           | Name:   Jennifer L. Deacon   |   | (Principal Accounting Officer)                       |
|           |                              |   |                                                 |
| /s/            | Robert M. Barlow                  |   | Director                                             |
|           | Name: Robert M. Barlow            |   |                                                 |
|           |                              |   |                                                 |
| /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          |   |                                                 |

 

80

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| /s/    | Nancy K. Falck            |   | Director |
|--------|---------------------------|--------|----------|
|   | Name: Nancy K. Falck      |   |     |
|   |                      |   |     |
| /s/    | John W. Fisher            |   | Director |
|   | Name: John W. Fisher      |   |     |
|   |                      |   |     |
| /s/    | Jones V. Isaac            |   | Director |
|   | Name: Jones V. Isaac      |   |     |
|   |                      |   |     |
| /s/    | J. Hamilton Lambert       |   | Director |
|   | Name: J. Hamilton Lambert |   |     |
|   |                      |   |     |
| /s/    | Harold E. Lieding         |   | Director |
|   | Name: Harold E. Lieding   |   |     |
|   |                      |   |     |
| /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   |   |     |

 

81

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**SECTION 302 CERTIFICATIONS**

 

**CERTIFICATION**

 

I, Bernard H. Clineburg,Chairman, President and Chief Executive Officer of Cardinal FinancialCorporation, certify that:

 

1.             I have reviewed this annual report on Form 10-KSB ofCardinal Financial Corporation;

 

2.             Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this annual report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.             The registrant’s other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave:

 

(a)           designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)           evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)           presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.             Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)           all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

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(b)           any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.             The registrant’s other certifying officers and I haveindicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 

 
| Date:  March  28, 2003 | /s/ Bernard H. Clineburg                                              |   |
|-----------------------------|-----------------------------------------------------------------------|--------|
|                        | Bernard H. Clineburg  Chairman, President and Chief Executive Officer |

 

83

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**SECTION 302 CERTIFICATIONS**

 

**CERTIFICATION**

 

I, Carl E. Dodson, Executive Vice President and ChiefFinancial Officer of Cardinal Financial Corporation, certify that:

 

1.             I have reviewed this annual report on Form 10-KSB ofCardinal Financial Corporation;

 

2.             Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the period coveredby this annual report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.             The registrant’s other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant andhave:

 

(a)           designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

 

(b)           evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

 

(c)           presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.             Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)           all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

 

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(b)           any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.             The registrant’s other certifying officers and I haveindicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and material weaknesses.

 

 
| Date:  March  28, 2003 |  /s/ Carl E.  Dodson                                            |   |
|-----------------------------|----------------------------------------------------------------------|--------|
|                        | Carl E. Dodson  Executive Vice President and Chief Financial Officer |

 

 

85

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**SECTION 302 CERTIFICATIONS**

 

**CERTIFICATION**

** **

** **

I, Jennifer L. Deacon, Vice President and Controller of CardinalFinancial Corporation, certify that:

 

1.             I have reviewedthis annual report on Form 10-KSB of Cardinal Financial Corporation; 

 

2.             Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report; 

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition,   results of operations andcash flows of the registrant as of, and for, the periods presented in this annualreport; 

 

4.             The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)           designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared; 

 

(b)           evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and 

 

(c)           presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.             The registrant’s other certifying officers and I havedisclosed, based on our most recent evaluation, to the registrant’s auditors andthe audit committee of registrant’s board of directors (or persons performingthe equivalent functions):

 

(a)           allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)           anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

                6.             The registrant’s other certifying officers and I haveindicated in this annual report whether there were significant changes ininternal controls or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

** **
| Date:  March  28, 2003 |   |   | \s\ Jennifer L. Deacon        |   |
|-----------------------------|--------|--------|-------------------------------|--------|
|                        |   |   | Jennifer L. Deacon            |   |
|                        |   |   | Vice President and Controller |   |

 

 

86

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**EXHIBITINDEX**

 
| 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    |   | Amended Bylaws of Cardinal Financial Corporation  (incorporated by reference to Exhibit 3.3 to the Quarterly Report on Form  10-QSB for the period ended June 30, 2002).                                                 |
|   |   |                                                                                                                                                                                                                     |
| 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.                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                     |
| 99.1   |   | Statement of Chief Executive Officer Pursuant to 18  U.S.C. § 1350.                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                     |
| 99.2   |   | Statement of Chief Financial Officer Pursuant to 18  U.S.C. § 1350.                                                                                                                                                 |

 

 

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