<PAGE>   1
                                                                      EXHIBIT 13




                         Allied Capital Corporation II

                            SHAREHOLDER INFORMATION


CORPORATE OFFICE
c/o Allied Capital Advisers, Inc.
1666 K Street, NW, 9th Floor
Washington, DC 20006
Telephone:                          (202) 331-1112                 
Facsimile:                          (202) 659-2053                 
News-On-Demand:                     (888) 329-5519                 
Investor Relations:                 (202) 973-6334                 
Investor Relations E-mail:          ir@alliedcapital.com           
Marketing:                          (202) 331-2439                 
Marketing E-mail:                   info@alliedcapital.com         
Internet Address:                   http://www.alliedcapital.com   

STOCK TRANSFER AGENT AND REGISTRAR
Inquiries on transferring securities, replacing a lost or stolen certificate,
participating in the Dividend Reinvestment Plan, requesting Direct Deposit
information or processing a change of address should be directed to: 
American Stock Transfer & Trust Company 
40 Wall Street, 46th Floor 
New York, NY 10005 
In the United States:               (800) 937-5449 
Outside the United States:          (212) 936-5100 
E-mail:                             info@amstock.com 
Internet Address:                   http://www.amstock.com

FORM 10-K REPORT
A copy of the Company's Annual Report on Form 10-K for the year ended December
31, 1996, as filed with the Securities and Exchange Commission, will be
furnished without charge to shareholders upon written request to the Investor
Relations Department at the Company's corporate offices. This information is
also available on Allied Capital's Internet site: http://www.alliedcapital.com

1997 ANNUAL MEETING OF SHAREHOLDERS
Montgomery Room at The Residence Inn by Marriott,
7335 Wisconsin Avenue, Bethesda, Maryland 20814
Friday, May 2, 1997
10 a.m. (EST)
All shareholders are welcome to attend.

INDEPENDENT ACCOUNTANTS
Matthews, Carter and Boyce, P.C.
McLean, VA

STOCK MARKET LISTING
Allied Capital Corporation II common stock is quoted on the Nasdaq National
Market under the ticker symbol ALII. Most newspapers list the Company's stock
as "AldCall". The Company has approximately 1,800 shareholders of record and
9,200 beneficial shareholders.

DIVIDENDS AND DISTRIBUTIONS
Generally, quarterly dividends on common stock are paid on the last business
day of each quarter. The Company has also paid a fifth distribution at year-end
since inception.

STOCK PRICE


<TABLE>
<CAPTION>
                High     Low      Close
                ----     ---      -----
<S>      <C>   <C>      <C>      <C>
1995     Q1    $14.75   $13.75   $14.13
         Q2     16.25    14.00    15.50
         Q3     16.25    15.00    15.75
         Q4     19.00    15.75    17.13

1996     Q1    $18.50   $16.25   $18.00
         Q2     18.50    15.50    18.25
         Q3     20.25    17.25    19.25
         Q4     21.88    18.75    21.25

</TABLE>

 
TOTAL DISTRIBUTIONS PER SHARE

<TABLE>
<CAPTION>

 1992    1993    1994    1995    1996
 ----    ----    ----    ----    ----
<S>     <C>     <C>     <C>     <C>
$1.15   $1.22   $1.34   $1.60   $1.92

</TABLE>


AVERAGE ANNUAL TOTAL RETURN


<TABLE>
<CAPTION>

    Value of $10,000 Investment January 1, 1990
 
  Year-End                 Value
  --------                 -----
<S>                     <C>
  1990                   $11,887
  1991                    14,061
  1992                    14,795
  1993                    12,570
  1994                    13,192
  1995                    18,257
  1996                    25,042

</TABLE>

A $10,000 investment in Allied Capital Corporation II as of January 1, 1990,
with all distributions reinvested, was worth $25,042 at the end of 1996, a 14%
average annual total return over this period.
<PAGE>   2
                         Allied Capital Corporation II

                                COMPANY PROFILE

Allied Capital Corporation II offers shareholders the opportunity to profit
from a portfolio of long-term debt and equity investments in growing businesses
nationwide. Managed by Allied Capital Advisers, Inc., the company seeks to
provide current income and  long-term capital appreciation for its
shareholders.

                              FINANCIAL HIGHLIGHTS

<TABLE>
<CAPTION>
                                                                                                December 31,
(in thousands, except per share amounts)                                                     1996         1995
--------------------------------------------------------------------------------------------------------------
<S>                                                                                      <C>          <C>
Total Investments at Value                                                               $ 86,266     $ 99,207
Total Assets                                                                             $106,908     $107,169
Shareholders' Equity (Net Asset Value)                                                   $102,838     $101,981
Net Increase in Net Assets Resulting from Operations                                     $ 10,149     $ 14,733
Earnings Per Share                                                                       $   1.38     $   2.11
Distributions Per Share                                                                  $   1.92     $   1.60
Number of Shares Outstanding                                                                7,550        7,104

</TABLE>


                         Allied Capital Corporation II

                                       1

<PAGE>   3
                         Allied Capital Corporation II

                CONSOLIDATED COMPARISON OF FINANCIAL HIGHLIGHTS

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
                                                                                   For the Years Ended December 31,
(in thousands, except per share amounts)                               1996         1995         1994        1993        1992
-----------------------------------------------------------------------------------------------------------------------------
<S>                                                                <C>          <C>          <C>         <C>          <C>
DISTRIBUTIONS   
Total tax distributions                                            $ 14,143     $ 11,206     $  9,297    $  8,454     $ 7,891
  Ordinary income per share                                        $   1.49     $   1.38     $   1.25    $   0.76     $  0.97
  Net capital gains per share                                          0.43         0.22         0.09        0.46        0.18
                                                                   ----------------------------------------------------------
    Total tax distributions per share                              $   1.92     $   1.60     $   1.34    $   1.22     $  1.15
-----------------------------------------------------------------------------------------------------------------------------
OPERATIONS   
Total investment income                                            $ 12,084     $ 11,539     $ 10,564    $  7,770     $ 8,864
  Per share                                                        $   1.65     $   1.65     $   1.52    $   1.12     $  1.29
Net investment income                                              $  9,148     $  8,350     $  7,425    $  5,315     $ 6,597
  Per share                                                        $   1.24     $   1.20     $   1.07    $   0.77     $  0.96
Net realized gains on investments                                  $  7,427     $  3,621     $  3,562    $    148     $ 1,297
Net unrealized appreciation (depreciation) on investments          $ (6,426)    $  2,762     $   (472)   $  5,011     $   948
Net realized gains and unrealized appreciation
  (depreciation) on investments                                    $  1,001     $  6,383     $  3,090    $  5,159     $ 2,245
  Per share                                                        $   0.14     $   0.91     $   0.45    $   0.74     $  0.33
Net increase in net assets resulting from operations               $ 10,149     $ 14,733     $ 10,515    $ 10,474     $ 8,842
  Per share                                                        $   1.38     $   2.11     $   1.52    $   1.51     $  1.29
Weighted average number of shares and
  share equivalents outstanding                                       7,343        6,979        6,940       6,951       6,875
-----------------------------------------------------------------------------------------------------------------------------
FINANCIAL POSITION
Investments at value                                               $ 86,266     $ 99,207     $ 88,130    $ 70,716     $47,739
Investments at cost                                                $ 87,011     $ 93,526     $ 85,211    $ 67,325     $49,359
Total assets                                                       $106,908     $107,169     $101,934    $100,151     $96,165
Shareholders' equity (net asset value)                             $102,838     $101,981     $ 97,475    $ 96,225     $93,891
  Per share                                                        $  13.62     $  14.36     $  14.05    $  13.87     $ 13.60
Per share market value at end of year                              $  21.25     $  17.13     $  13.63    $  14.25     $ 18.00
Shares outstanding at end of year                                     7,550        7,104        6,938       6,938       6,906
</TABLE>






                         Allied Capital Corporation II

                                       9

<PAGE>   4
                         Allied Capital Corporation II

                      MANAGEMENT'S DISCUSSION AND ANALYSIS

The following discussion should be read in conjunction with the financial
statements and notes thereto included elsewhere in this report.

LIQUIDITY AND CAPITAL RESOURCES

Allied Capital Corporation II (Company) had $18.5 million in total cash
available at December 31, 1996 and had an available credit facility of $25.0
million. At December 31, 1996, outstanding commitments for future financings by
the Company were $3.1 million.  Given the balance of cash available at December
31, 1996 and the available credit facility, the Company believes that it has
adequate capital to continue to satisfy its operating needs, commitments and
other future investment opportunities that may arise throughout 1997.

RESULTS OF OPERATIONS

COMPARISON OF 1996 AND 1995

The net increase in net assets resulting from operations was $10.1 million, or
$1.38 per share, for the year ended December 31, 1996, compared to $14.7
million, or $2.11 per share, for the same period in 1995. Net realized gains on
investments were $7.4 million for the year ended December 31, 1996 as compared
to $3.6 million for the same period of the prior year. During 1996, the Company
successfully liquidated certain equity investments and received early payoffs
of loans in its portfolio. Since net gains are realized when the Company sells
or otherwise liquidates its investments, profit from net gains may vary
significantly from year to year.

The investments that generated the 1996 net realized gains had previously been
valued by the board of directors such that the Company had recorded net
unrealized appreciation totaling $3.4 million, or $0.46 per share. When the
investments were liquidated in 1996, the profit resulting from the net gains
was reduced by an offsetting decrease in net unrealized appreciation for the
$3.4 million previously recorded. The Company recorded additional portfolio
depreciation of $3.0 million for the year resulting from the valuations as
determined by the board of directors.

Total investment income increased 5% to $12.1 million for 1996 as compared to
$11.5 million for 1995. Interest income increased by $1.2 million, or 11%, to
$11.9 million in 1996, compared to $10.7 million in 1995, due to an increase in
loan discount amortization and the early recognition of loan fees on early
repayments. The Company also received prepayment penalties totaling $95,000 in
1996 as compared to $270,000 in 1995, which are included in other income. Other
income for the year ended December 31, 1995 included non-recurring income of
$308,000 resulting from litigation costs incurred in prior periods which were
recovered during 1995.

Total expenses decreased $0.3 million to $2.9 million in 1996 as compared to
$3.2 million in 1995. The Company's investment advisory fee remained level at
$2.4 million for 1996 and 1995. Other expenses decreased 33% for 1996




                         Allied Capital Corporation II


                                       10

<PAGE>   5
                         Allied Capital Corporation II

                      MANAGEMENT'S DISCUSSION AND ANALYSIS

as compared to 1995. This decline resulted from a decline in legal costs 
related to litigation that was resolved in late 1994.

Distributions to shareholders for 1996 were $14.1 million. The Company's
taxable income of $1.92 per share differed significantly from its net
investment income before net unrealized appreciation (depreciation) on
investments of $2.26 per share due to timing differences in the recognition of
income for tax purposes versus financial reporting purposes. The distributions
were comprised of taxable ordinary and net capital gain income.

COMPARISON OF 1995 AND 1994

Net increase in net assets resulting from operations increased 40% to $14.7
million for the year ended December 31, 1995 as compared to $10.5 million for
the same period in 1994. Earnings per share was $2.11 for 1995 versus $1.52 for
1994.

Total investment income increased 9% from $10.6 million in 1994 to $11.5
million in 1995. Interest income grew due to a net increase in the Company's
outstanding loans and debt securities of $7.4 million in 1995.

Total expenses of $3.2 million in 1995 were slightly higher than 1994 expenses
of $3.1 million. Investment advisory fee expense increased due to an increase
in the Company's portfolio investments and other assets upon which the
investment advisory fee is based. Legal and accounting fees in 1995 were down
from the prior year as the Company settled various legal matters in late 1994,
which required significant legal resources in that year.

Net realized gains on investments were $3.6 million in both 1995 and 1994. The
1995 net realized gains resulted from exiting certain mature investments and
the early pay off of investments. Net unrealized appreciation was $2.8 million
in 1995 as compared to net unrealized depreciation of $0.5 million in 1994.

Taxable distributions to shareholders for 1995 were $11.2 million, or $1.60 per
share. Taxable income differed from net investment income before net unrealized
appreciation on investments due to timing differences in the recognition of
income for tax purposes versus financial reporting purposes. The distributions
were comprised of taxable ordinary and net capital gain income.

INVESTMENT PORTFOLIO

Total investments decreased by $12.9 million or 13% to $86.3 million at
December 31, 1996 from $99.2 million at December 31, 1995.  The Company
invested $25.8 million in small business concerns in 1996, a 33% decrease
compared to $38.3 million invested in 1995. As a result of declining interest
rates and the greater flow of capital into the marketplace, investment exits
and repayments totaled $32.3 million in 1996 as compared to $30.0 million in
1995. For the year ended December 31, 1996, the Company's portfolio experienced
net depreciation of $6.4






                         Allied Capital Corporation II


                                       11

<PAGE>   6
                         Allied Capital Corporation II

                      MANAGEMENT'S DISCUSSION AND ANALYSIS

million due to various factors including the sale of certain investments which
resulted in net realized gains.

FACTORS AFFECTING THE COMPANY'S BUSINESS

Nature of Investments. Consistent with its operation as a business development
company, the Company's portfolio is expected to consist primarily of securities
issued by small and developing, privately-held companies. Typically, such
companies each depend for their success on the management talents and efforts
of one person, so that the death, disability or resignation of such person
could have a materially adverse impact on the companies. Moreover, smaller
companies frequently have narrower product lines and smaller market shares than
larger companies and therefore may be more vulnerable to competitors' actions
and market conditions, as well as general economic downturns. Because these
companies will generally have highly leveraged capital structures, reduced cash
flow resulting from an adverse competitive development, shift in customer
preferences, or an economic downturn may adversely affect the return on, or the
recovery of, the Company's investment in them. Investment in such companies
therefore involves a high degree of business and financial risk, which can
result in substantial losses and accordingly should be considered speculative.

Long-term Character of Investments. It is expected that investments made in
accordance with the Company's investment objective will usually yield a current
return from the time they are made, but will generally produce a profit, if
any, from an accompanying equity feature only after five to eight years. There
can be no assurance that either a current return or capital gains will actually
be achieved.

Illiquidity. Most of the Company's investments consist of securities acquired
directly from the issuers in private transactions.  They are usually subject to
restrictions on resale or otherwise illiquid. There is usually no established
trading market for such securities into which they could be sold. In addition,
most of the securities are not eligible for sale to the public without
registration which would involve delay and expense.

Competition. A large number of entities and individuals compete for the
opportunity to make the kinds of investments made by the Company. Many of these
entities and individuals have greater financial resources than the combined
resources of the Company. As a result of this competition, the Company may from
time to time be precluded from making otherwise attractive investments on terms
considered to be prudent in light of the risks to be assumed.

   Statements included in this report concerning the Company's future prospects
   are "forward looking statements" under the Federal securities laws. There
   can be no assurance that future results will be achieved and actual results
   could differ materially from forecasts and estimates.





                         Allied Capital Corporation II



                                       12
<PAGE>   7
                         Allied Capital Corporation II

                           CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------
                                                                                                     December 31,
(in thousands, except number of shares)                                                           1996         1995
-------------------------------------------------------------------------------------------------------------------
<S>                                                                                           <C>          <C>
ASSETS   
Investments at Value:
Loans and debt securities (cost: 1996--$80,859; 1995--$86,474)                                $ 74,505     $ 84,235
Equity securities (cost: 1996--$5,956; 1995--$5,538)                                            11,613       13,548
Other investment assets (cost: 1996--$196; 1995--$1,514)                                           148        1,424
                                                                                              ---------------------
    Total investments                                                                           86,266       99,207

Cash and cash equivalents                                                                       18,525        6,227
Other assets                                                                                     2,117        1,735
                                                                                              ---------------------
    Total assets                                                                              $106,908     $107,169
                                                                                              =====================

LIABILITIES AND SHAREHOLDERS' EQUITY   
Liabilities:
Dividends and distributions payable                                                           $  3,379     $  3,403
Investment advisory fee payable                                                                    576          639
Other liabilities                                                                                  115        1,146
                                                                                              ---------------------
    Total liabilities                                                                            4,070        5,188
                                                                                              ---------------------
Commitments and Contingencies
Shareholders' Equity:
Common stock, $1 par value, 20,000,000 shares authorized; 7,550,198 and
  7,104,005 shares issued and outstanding at December 31, 1996 and 1995                          7,550        7,104
Additional paid-in capital                                                                      99,522       92,225
Notes receivable from sale of common stock                                                      (5,387)      (2,495)
Net unrealized appreciation (depreciation) on investments                                         (745)       5,681
Undistributed (distributions in excess of) accumulated earnings                                  1,898         (534)
                                                                                              ---------------------
    Total shareholders' equity                                                                 102,838      101,981
                                                                                              =====================
    Total liabilities and shareholders' equity                                                $106,908     $107,169
                                                                                              =====================
The accompanying notes are an integral part of these financial statements.
</TABLE>






                         Allied Capital Corporation II


                                       13
<PAGE>   8
                         Allied Capital Corporation II

                      CONSOLIDATED STATEMENT OF OPERATIONS

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------------------
                                                                                                  For the Years Ended December 31,
(in thousands, except per share amounts)                                                          1996          1995         1994
----------------------------------------------------------------------------------------------------------------------------------
<S>                                                                                             <C>           <C>         <C>
Investment Income:
  Interest                                                                                      $11,894       $10,686     $10,434
  Other income                                                                                      190           853         130
                                                                                                ----------------------------------
    Total investment income                                                                      12,084        11,539      10,564
                                                                                                ----------------------------------
Expenses:
  Investment advisory fee                                                                         2,438         2,445       2,145
  Legal and accounting fees                                                                         197           343         695
  Other operating expenses                                                                          301           401         299
                                                                                                ----------------------------------
    Total expenses                                                                                2,936         3,189       3,139
                                                                                                ----------------------------------
Net investment income                                                                             9,148         8,350       7,425
Net realized gains on investments                                                                 7,427         3,621       3,562
                                                                                                ----------------------------------
Net investment income before net unrealized appreciation (depreciation) on investments           16,575        11,971      10,987
Net unrealized appreciation (depreciation) on investments                                        (6,426)        2,762        (472)
                                                                                                ----------------------------------
Net increase in net assets resulting from operations                                            $10,149       $14,733     $10,515
                                                                                                ==================================
Earnings per share                                                                              $  1.38       $  2.11     $  1.52
                                                                                                ==================================
Weighted average number of shares and share equivalents outstanding                               7,343         6,979       6,940
                                                                                                ==================================
</TABLE>
The accompanying notes are an integral part of these financial statements.


                         Allied Capital Corporation II



                                       14
<PAGE>   9
                         Allied Capital Corporation II

                CONSOLIDATED STATEMENT OF CHANGES IN NET ASSETS

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
                                                                                     For the Years Ended December 31,
(in thousands, except per share amounts)                                               1996         1995       1994
--------------------------------------------------------------------------------------------------------------------
<S>                                                                                <C>          <C>         <C>
Increase in Net Assets Resulting from Operations:
  Net investment income                                                            $  9,148     $  8,350    $ 7,425
  Net realized gains on investments                                                   7,427        3,621      3,562
  Net unrealized appreciation (depreciation) on investments                          (6,426)       2,762       (472)
                                                                                   ---------------------------------
    Net increase in net assets resulting from operations                             10,149       14,733     10,515
                                                                                   ---------------------------------
Distributions to Shareholders from:
  Net investment income                                                             (10,955)      (9,622)    (7,390)
  Excess of net investment income                                                        --           --     (1,301)
  Net capital gains                                                                  (3,188)      (1,584)      (606)
                                                                                   ---------------------------------
    Net decrease in net assets resulting from distributions to shareholders         (14,143)     (11,206)    (9,297)
                                                                                   ---------------------------------
Capital Share Transactions:
  Net (increase) decrease in notes receivable from sale of common stock              (2,892)      (1,552)        32
  Issuance of common stock upon the exercise of stock options                         3,766        1,910         --
  Issuance of common stock in lieu of cash distributions                              3,977          621         --
                                                                                   ---------------------------------
    Net increase in net assets resulting from capital share transactions              4,851          979         32
                                                                                   ---------------------------------
Total increase in net assets                                                            857        4,506      1,250
Net assets at beginning of year                                                     101,981       97,475     96,225
                                                                                   ---------------------------------
Net assets at end of year                                                          $102,838     $101,981    $97,475
                                                                                   =================================
Net asset value per share                                                          $  13.62     $  14.36    $ 14.05
                                                                                   =================================
Shares outstanding at end of year                                                     7,550        7,104      6,938
                                                                                   =================================
</TABLE>
The accompanying notes are an integral part of these financial statements.


                         Allied Capital Corporation II


                                       15
<PAGE>   10
                         Allied Capital Corporation II

                      CONSOLIDATED STATEMENT OF CASH FLOWS

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
                                                                                     For the Years Ended December 31,
(in thousands, except per share amounts)                                              1996         1995        1994
--------------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>          <C>         <C>
Cash Flows from Operating Activities:
  Net increase in net assets resulting from operations                            $ 10,149     $ 14,733    $ 10,515
  Adjustments to reconcile net increase in net assets resulting from
  operations to net cash provided by operating activities:
      Net unrealized (appreciation) depreciation on investments                      6,426       (2,762)        472
      Write-off of investments                                                       1,616          657         607
      Net realized gains on investments                                             (9,043)      (4,278)     (4,169)
      Interest income                                                                   --           --      (1,469)
      Amortization of loan discounts                                                (1,099)        (967)       (906)
      Changes in assets and liabilities:
        Other assets                                                                  (382)         256         (83)
        Investment advisory fee payable                                                (63)          60         108
        Other liabilities                                                           (1,031)        (244)       (407)
                                                                                  ----------------------------------
          Net cash provided by operating activities                                  6,573        7,455       4,668
                                                                                  ----------------------------------
Cash Flows from Investing Activities:
  Investments in small business concerns                                           (25,752)     (38,264)    (28,408)
  Purchase of U.S. government securities                                                --         (345)     (8,460)
  Payments on loans and debt securities and other investment assets                 32,073       31,004      12,927
  Net proceeds from sale of equity securities                                        8,720        2,869       3,294
  Redemption of U.S. government securities                                              --        1,100      25,055
  Payments on notes receivable from sale of common stock                               874          358          32
                                                                                  ----------------------------------
          Net cash provided by (used in) investing activities                       15,915       (3,278)      4,440
                                                                                  ----------------------------------
Cash Flows from Financing Activities:
  Dividends and distributions paid                                                 (10,190)      (9,541)     (8,464)
                                                                                  ----------------------------------
          Net cash used in financing activities                                    (10,190)      (9,541)     (8,464)
                                                                                  ----------------------------------
Net increase (decrease) in cash and cash equivalents                                12,298       (5,364)        644
Cash and cash equivalents, beginning of year                                         6,227       11,591      10,947
                                                                                  ----------------------------------
Cash and cash equivalents, end of year                                            $ 18,525     $  6,227    $ 11,591
                                                                                  ==================================
Supplemental Disclosure of Cash Flow Information
  Noncash investing and financing activities:
    Issuance of common stock upon the exercise of stock options                   $  3,766     $  1,910     $    --
    Issuance of common stock in lieu of cash distributions                        $  3,977     $    621     $    --
</TABLE>

The accompanying notes are an integral part of these financial statements.


                         Allied Capital Corporation II



                                       16
<PAGE>   11
                         Allied Capital Corporation II

                CONSOLIDATED STATEMENT OF LOANS AND INVESTMENTS

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
Company's Name (State)                                                                             December 31, 1996
(Type of Business)                                 Investments                                      Cost       Value
--------------------------------------------------------------------------------------------------------------------
<S>                                                <C>                                           <C>         <C>
(in thousands, except number of shares)
Loans With Equity
--------------------------------------------------------------------------------------------------------------------
Acme Paging, L.P. (IL)                             Loans and Debt Securities                     $ 1,646     $ 1,646
(South American paging service)                    Limited Partnership Interest (0.52%)              416         416
--------------------------------------------------------------------------------------------------------------------
Allied Waste Industries, Inc. (AZ) (1)             Warrants                                          103       1,651
(solid waste collection and disposal)
--------------------------------------------------------------------------------------------------------------------
American Barbecue & Grill (KS)                     Loans and Debt Securities                       1,600       1,600
(restaurants)                                      Warrants                                           54          54
--------------------------------------------------------------------------------------------------------------------
ASW Holding Corporation (IL)                       Loans and Debt Securities                       1,425       1,425
(steel wool manufacturer)                          Warrants                                           47         323
--------------------------------------------------------------------------------------------------------------------
Au Bon Pain Co., Inc. (MA) (1)                     Loans and Debt Securities                       3,718       3,718
(bakery cafes)                                     Warrants (3)                                      118           0
--------------------------------------------------------------------------------------------------------------------
Brazos Sportswear, Inc. (OH)                       Loans and Debt Securities                       1,247       1,247
(manufacturer and distributor of sportswear)       Common Stock (18,091 shares)                      132         132
                                                   Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
CeraTech Holdings, Inc. (IL)                       Loans and Debt Securities                         811         401
(ceramic plate manufacturer)                       Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
Cherry Tree Toys, Inc. (OH)                        Loans and Debt Securities                         940         940
(direct marketer of woodcrafts)                    Common Stock (103 shares)                           0           0
--------------------------------------------------------------------------------------------------------------------
Colorado Prime Corporation (NY)                    Loans and Debt Securities                       4,957       4,957
(home food delivery)                               Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
Convenience Corporation of America (NE)            Loans and Debt Securities                       4,223       4,223
(convenience stores)                               Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
Contemporary Media, Inc. (ID)                      Loans and Debt Securities                         437         437
(radio stations)                                   Warrants                                          160         206
--------------------------------------------------------------------------------------------------------------------
Cooper Natural Resources, Inc. (TX)                Loans and Debt Securities                       1,372       1,372
(sodium sulfate producer)                          Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
DEH Printed Circuits, Inc. (IL)                    Warrants                                          117         170
(circuit board manufacturer)
--------------------------------------------------------------------------------------------------------------------
DeVlieg-Bullard, Inc. (CT) (1)                     Warrants (3)                                      144         224
(tool manufacturer)
--------------------------------------------------------------------------------------------------------------------
El Dorado Communications, Inc. (CA)                Loans and Debt Securities                       4,851       4,851
(radio stations)                                   Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
Enviroplan, Inc. (NJ) (2)                          Loans and Debt Securities                       1,935         403
(emissions monitoring systems)                     Warrants                                           94           0
--------------------------------------------------------------------------------------------------------------------
Esquire Communications, Ltd. (NY) (1)              Warrants (3)                                        3           0
(court reporting services)
--------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Public company; (2) Interest not being accrued; (3) Restricted public
security

The accompanying notes are an integral part of these financial statements.


                         Allied Capital Corporation II



                                       17
<PAGE>   12
                         Allied Capital Corporation II

                CONSOLIDATED STATEMENT OF LOANS AND INVESTMENTS


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
Company's Name (State)                                                                             December 31, 1996
(Type of Business)                                 Investments                                      Cost       Value
--------------------------------------------------------------------------------------------------------------------
<S>                                                <C>                                           <C>         <C>
(in thousands, except number of shares)
Fairchild Industrial Products Company (NC)         Loans and Debt Securities                     $ 2,245     $ 2,245
(industrial controls and power transmissions)      Warrants                                          112         112
--------------------------------------------------------------------------------------------------------------------
Garden Ridge Corporation (TX) (1)                  Common Stock (163,044 shares)                     449       1,281
(home decorating and craft products)
--------------------------------------------------------------------------------------------------------------------
Grant Broadcasting Systems II (FL)                 Warrants                                           61       1,056
(television stations)
--------------------------------------------------------------------------------------------------------------------
Grant Television, Inc. (FL)                        Loans and Debt Securities                       2,738       2,738
(television stations)                              Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
Gulf South Medical Supply, Inc. (MS) (1)           Loans and Debt Securities                         360         360
(medical supplies distributor)                     Warrants (3)                                       70          70
--------------------------------------------------------------------------------------------------------------------
Innotech, Inc. (VA) (1)                            Warrants (3)                                       30           0
(bifocal lens manufacturer)
--------------------------------------------------------------------------------------------------------------------
Julius Koch USA, Inc. (MA)                         Loans and Debt Securities                       1,830       1,830
(cord manufacturer)                                Warrants                                          129         129
--------------------------------------------------------------------------------------------------------------------
Kirker Enterprises, Inc. (NJ)                      Loans and Debt Securities                       1,504       1,504
(nail enamel manufacturer)                         Warrants                                          146         146
--------------------------------------------------------------------------------------------------------------------
Kirkland's, Inc. (TN)                              Loans and Debt Securities                       2,721       2,721
(retailer of home products)                        Warrants                                           42          42
--------------------------------------------------------------------------------------------------------------------
Labor Ready, Inc. (WA) (1)                         Common Stock (146,534 shares)                   1,310       1,935
(temporary labor services)
--------------------------------------------------------------------------------------------------------------------
Liberty Business Forms & Systems, Inc. (NY)        Loans and Debt Securities                       1,436       1,436
(inventory control tags and forms)                 Warrants                                           43          43
--------------------------------------------------------------------------------------------------------------------
Midview Associates, L.P. (VA)                      Loans and Debt Securities                         155         155
(residential land development)                     Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
Mill-It Striping, Inc. (FL)                        Warrants                                          125           0
(highway paint striping)
--------------------------------------------------------------------------------------------------------------------
Montgomery Tank Lines (FL) (1)                     Common Stock (17,701 shares)                       75         359
(tank truck carrier)
--------------------------------------------------------------------------------------------------------------------
Nobel Education Dynamics, Inc. (PA) (1)            Preferred Stock (166,223 shares) (3)            1,250       1,424
(educational services)                             Warrants (3)                                        0         202
--------------------------------------------------------------------------------------------------------------------
Old Mill Holdings, Inc. (PA) (2)                   Loans and Debt Securities                         469         324
(custom embroidered apparel)                       Warrants                                           32           0
--------------------------------------------------------------------------------------------------------------------
The Peerless Group, Inc. (TX) (1)                  Common Stock (253,240 shares) (3)                  12       1,401
(commercial banking software development)
--------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Public company; (2) Interest not being accrued; (3) Restricted public
security

The accompanying notes are an integral part of these financial statements.



                         Allied Capital Corporation II


                                       18
<PAGE>   13
                         Allied Capital Corporation II

                CONSOLIDATED STATEMENT OF LOANS AND INVESTMENTS


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
Company's Name (State)                                                                             December 31, 1996
(Type of Business)                                 Investments                                      Cost       Value
--------------------------------------------------------------------------------------------------------------------
<S>                                                <C>                                           <C>         <C>
(in thousands, except number of shares
and number of loans)
Pico Products, Inc. (CA) (1)                       Loans and Debt Securities                     $ 2,000     $ 2,000
(manufacturer of satellite/television components)  Warrants (3)                                        0           0
--------------------------------------------------------------------------------------------------------------------
Quality Software Products Holdings, PLC (UK) (1)   Common Stock (41,571 shares)                      396         148
(accounting software)
--------------------------------------------------------------------------------------------------------------------
Radio One of Atlanta, Inc. (GA)                    Loans and Debt Securities                       1,853       1,853
(radio stations)                                   Warrants                                            0           0
--------------------------------------------------------------------------------------------------------------------
R-Tex Decoratives Company, Inc. (PA)               Loans and Debt Securities                         659         659
(decorative ribbon manufacturer)                   Warrants                                           25          25
--------------------------------------------------------------------------------------------------------------------
Steuart Petroleum (DC)                             Warrants                                           48          48
(petroleum products)
--------------------------------------------------------------------------------------------------------------------
West Virginia Radio Corporation (WV)               Loans and Debt Securities                         527         527
(radio station)                                    Warrants                                          200           0
--------------------------------------------------------------------------------------------------------------------
Williams Brothers Lumber Company (GA)              Loans and Debt Securities                       1,060       1,060
(builders' supply yards)                           Warrants                                            9           9
--------------------------------------------------------------------------------------------------------------------
Z-Spanish Radio Network (CA)                       Loans and Debt Securities                       5,187       5,187
(radio stations)                                   Warrants                                            2           2
--------------------------------------------------------------------------------------------------------------------
Subtotal                                                                                         $59,860     $63,427
--------------------------------------------------------------------------------------------------------------------
Loans With No Equity By Industry
--------------------------------------------------------------------------------------------------------------------
Hotels/Motels (3 loans)                                                                          $ 3,606     $ 3,606
--------------------------------------------------------------------------------------------------------------------
Mobile Home Parks (3 loans)                                                                        4,694       4,694
--------------------------------------------------------------------------------------------------------------------
Moving/Storage Company (1 loan)                                                                      572         572
--------------------------------------------------------------------------------------------------------------------
Pet Products Manufacturer (1 loan)                                                                 2,669       2,669
--------------------------------------------------------------------------------------------------------------------
Radio Stations (5 loans)                                                                           9,487       9,487
--------------------------------------------------------------------------------------------------------------------
Retail Shops (1 loan)                                                                                373         373
--------------------------------------------------------------------------------------------------------------------
Cold Food Storage Warehouse (1 loan) (2)                                                           5,266       1,016
--------------------------------------------------------------------------------------------------------------------
Other (6 loans)                                                                                      288         273
--------------------------------------------------------------------------------------------------------------------
Subtotal                                                                                         $26,955     $22,690
--------------------------------------------------------------------------------------------------------------------
Other Investment Assets (4)                                                                      $    64     $    17
--------------------------------------------------------------------------------------------------------------------
Pledged Certificate of Deposit                                                                       132         132
--------------------------------------------------------------------------------------------------------------------
Subtotal                                                                                         $   196     $   149
--------------------------------------------------------------------------------------------------------------------
Total                                                                                            $87,011     $86,266
--------------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Public company; (2) Interest income not being accrued; (3) Restricted
public security; (4) Non-income producing

The accompanying notes are an integral part of these financial statements.



                         Allied Capital Corporation II


                                       19
<PAGE>   14
                         Allied Capital Corporation II

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION. Allied Capital Corporation II (the Company) is a closed-end
management investment company that has elected to be regulated as a business
development company under the Investment Company Act of 1940 (1940 Act). The
Company seeks to achieve current income by providing debt, mezzanine and equity
financing, primarily for small privately owned growth companies, and through
long-term growth in the value of its net assets. The Company has two wholly
owned, registered investment company subsidiaries, Allied Investment
Corporation II (Allied Investment II) and Allied Financial Corporation II
(Allied Financial II). Allied Investment II and Allied Financial II are
licensed under the Small Business Investment Act of 1958 as a Small Business
Investment Company (SBIC) and a Specialized Small Business Investment Company
(SSBIC), respectively.

The Company has an investment advisory agreement with Allied Capital Advisers,
Inc. (Advisers), whereby Advisers manages the investments of the Company
subject to the supervision and control of the Company's board of directors.
Certain directors and officers of Advisers are also directors and officers of
the Company.

CO-INVESTMENTS. Investments made by the Company are made in participation with
a separately organized public closed-end management investment company and two
private venture capital partnerships, which are also managed by Advisers in
accordance with the conditions of an exemptive order issued to the Company by
the Securities and Exchange Commission (Commission) permitting co-investments.

PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries after elimination of
intercompany balances and transactions.

VALUATION OF INVESTMENTS. Investments are carried at value, as determined by
the board of directors.

Loans and debt securities, which are not publicly traded, and warrants and
stocks for which there is no public market are valued based on collateral, the
ability to make payments, the earnings of the investee and other pertinent
factors. The values assigned are considered to be amounts which could be
realized in the normal course of business or from an orderly sale or other
disposition of the investments. In the normal course of business, loans and
debt securities are held to maturity, and the amount realized, in addition to
interest, is the face value, which may equal or exceed cost.

Equity securities which are publicly traded are generally valued at their
quoted market price, less a discount to reflect the effects of restrictions on
the sale of such securities.

Cash and cash equivalents are carried at cost which approximates fair value.

INTEREST INCOME. Interest income is recorded on the accrual basis to the extent
that such amounts are expected to be collected. Loan fees and original issue
discount are amortized into interest income using the effective interest
method.

REALIZED GAINS OR LOSSES AND UNREALIZED APPRECIATION OR DEPRECIATION ON
INVESTMENTS. Realized gains or losses are measured by the difference between
the net proceeds from the sale and the cost basis of the investment without
regard to unrealized appreciation or depreciation previously recognized, and
include investments written off during the year, net of recoveries. Unrealized
appreciation or depreciation reflects the change in the valuation of the
portfolio.

DISTRIBUTIONS TO SHAREHOLDERS. Distributions to shareholders are recorded on
the ex-dividend date.

FEDERAL INCOME TAXES. The Company and its wholly owned subsidiaries' objectives
are to comply with the requirements of the Internal Revenue Code that are
applicable to regulated investment companies. The Company and its wholly owned
subsidiaries annually distribute all of their taxable income to their
shareholders; therefore, a federal income tax provision is not required.

In addition, no provision for deferred income taxes has been made for the
unrealized appreciation on investments since the Company and its wholly owned
subsidiaries intend to continue to annually distribute all of their taxable
income.



                         Allied Capital Corporation II



                                       20
<PAGE>   15
                         Allied Capital Corporation II

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Dividends declared by the Company in December that are payable to shareholders
of record on a specified date in such month, but paid during January of the
following year, are treated as if the dividends were received by the
shareholder on December 31 of the year declared.

EARNINGS PER SHARE. Earnings are defined as the net investment income, net
realized gains on investments and net unrealized appreciation or depreciation
on investments. The computation of earnings per share is based on the weighted
average number of shares and share equivalents outstanding during the period.
Equivalent shares included in the computation represent shares issuable upon
assumed exercise of stock options which would have a dilutive effect in years
where there are earnings.

CASH AND CASH EQUIVALENTS. Cash equivalents consist of highly liquid
investments with insignificant interest rate risk and original maturities of
three months or less at the acquisition date. At December 31, cash and cash
equivalents consisted of the following:

<TABLE>
<CAPTION>
--------------------------------------------------------
(in thousands)                              1996    1995
--------------------------------------------------------
<S>                                      <C>     <C>
Cash                                     $   481  $  309
Repurchase agreements                     18,044   5,918
                                         ---------------
  Total                                  $18,525  $6,227
                                         ===============
--------------------------------------------------------
</TABLE>

On December 31, 1996, the Company had purchased $18,044,000 of overnight
repurchase agreements collateralized by U.S. Government securities under
agreements to resell on January 2, 1997. Due to the short-term nature of the
agreements, the Company did not take possession of the securities which were
instead held for the Company by the bank.

RECLASSIFICATIONS. Certain reclassifications have been made to the 1995 and
1994 financial statements to conform with the 1996 financial statement
presentation.

NOTE 2. INVESTMENTS

Loans and debt securities have stated interest rates ranging from generally 8
percent to 16 percent, and are generally payable in installments with final
maturities from 3 to 12 years from date of issue. At December 31, 1996 and
1995, loans and debt securities with a cost basis of $7,796,000 and $7,962,000,
respectively, were not accruing interest.

The investments of the Company and its subsidiaries consist primarily of
securities issued by privately owned companies. A majority of the securities
held by the Company are subject to restrictions on their resale or are
otherwise illiquid and cannot be sold to the public without registration under
the Securities Act of 1933. All of the Company's equity securities are
non-income producing except for its investment in Quality Software Products
Holdings, PLC.

The following industries represent five percent or more of the total value of
the investments outstanding at December 31:

<TABLE>
<CAPTION>
--------------------------------------------------------
                                             1996   1995
--------------------------------------------------------
<S>                                         <C>    <C>
Broadcasting                                 31%    26%
Manufacturing/construction                   23%    14%
Real estate                                   6%    13%
Retail                                       23%    18%
Service                                       9%    16%
Software                                      2%     5%
--------------------------------------------------------
</TABLE>

The net unrealized appreciation for all securities over cost for federal income
tax purposes at December 31:

<TABLE>
<CAPTION>
--------------------------------------------------------
(in thousands)                            1996     1995
--------------------------------------------------------
<S>                                    <C>      <C>
Aggregate gross unrealized
  appreciation in which there is
an excess of value over cost           $ 7,883  $10,736
Aggregate gross unrealized
  depreciation in which there is
an excess of cost over value            (7,327)  (5,805)
                                        ----------------
Net unrealized appreciation             $  556  $ 4,931
                                        ================
--------------------------------------------------------
</TABLE>

The aggregate cost of securities at December 31, 1996 and 1995 for federal
income tax purposes was $85,710,000 and $94,276,000, respectively.


                         Allied Capital Corporation II



                                       21
<PAGE>   16
                         Allied Capital Corporation II

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3. INVESTMENT ADVISORY AGREEMENT

The Company has an investment advisory agreement with Advisers that is approved
at least annually by the board of directors or by vote of the holders of a
majority of the outstanding shares of the Company. The agreement may be
terminated at any time on sixty days' notice, without penalty, by the Company's
board of directors or by vote of the holders of a majority of the Company's
outstanding shares and will terminate automatically in the event of its
assignment.

The Company pays all operating expenses, except those specifically required to
be borne by Advisers. The expenses paid by Advisers include the compensation of
the Company's officers and the cost of office space, equipment and other
personnel required for the Company's day-to-day operations. The expenses that
are paid by the Company include the Company's share of transaction costs
incident to the acquisition and disposition of investments, legal and
accounting fees, the fees and expenses of the Company's independent directors
and the fees of its officer-directors, the costs of printing and mailing proxy
statements and reports to shareholders, costs associated with promoting the
Company's stock, and the fees and expenses of the Company's custodian and
transfer agent. The Company is also required to pay expenses associated with
litigation and other extraordinary or non-recurring expenses, as well as
expenses of required and optional insurance and bonding. All fees paid by or
for the account of an actual or prospective portfolio company in connection
with an investment transaction in which the Company participates are received
by the Company, pro rata to its participation in such transaction, rather than
by Advisers. Advisers is entitled to retain for its own account any fees paid
by or for the account of a company, including a portfolio company, for special
investment banking or consulting work performed for that company which is not
related to such investment transaction or management assistance. As
compensation for its services to and the expenses paid for the account of the
Company, Advisers is paid a fee, quarterly in arrears. Beginning in the second
quarter of 1995, a fee was paid equal to 0.625 percent per quarter of the
quarter-end value of the Company's consolidated total assets, less interim
investments (i.e., U.S. government securities) and cash and cash equivalents,
plus 0.125 percent per quarter of the quarter-end value of consolidated interim
investments, cash and cash equivalents. These fees on an annual basis
approximate 2.5 percent on consolidated invested assets and 0.5 percent on
consolidated interim investments, cash and cash equivalents. In the first
quarter of 1995, and in 1994, Advisers was entitled to a fee equal to 0.625
percent per quarter of the quarter-end value of the Company's consolidated
total assets; however, Advisers waived a portion of its fee and agreed to a fee
equal to 0.625 percent per quarter of the quarter-end value of the consolidated
total assets excluding consolidated interim investments, cash and cash
equivalents, plus 0.125 percent per quarter of the quarter-end value of the
consolidated interim investments, cash and cash equivalents.

NOTE 4. DIVIDENDS AND DISTRIBUTIONS

The Company's board of directors declared and the Company paid a $0.41 per
share dividend for the fourth quarter, a $0.38 per share dividend for the third
quarter, a $0.35 per share dividend for the second quarter and a $0.33 per
share dividend for the first quarter of 1996. The Company's board of directors
also declared an extra distribution in the fourth quarter of $0.45 per share,
which was paid to shareholders on January 31, 1997, for a total distribution in
1996 equal to $1.92 per share.  The components of the dividends and
distributions of taxable income declared by the board of directors for 1996,
1995 and 1994 were as follows:

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------------
                                                             1996                    1995                 1994
                                                                      Per                   Per                  Per
(in thousands, except per share amounts)                Amount      Share      Amount     Share     Amount     Share
--------------------------------------------------------------------------------------------------------------------
<S>                                                    <C>          <C>       <C>         <C>       <C>        <C>
Ordinary income                                        $10,955      $1.49     $ 9,622     $1.38     $8,691     $1.25
Long-term capital gains                                  3,188       0.43       1,584      0.22        606      0.09
                                                       -------------------------------------------------------------
  Total distributions                                  $14,143      $1.92     $11,206     $1.60     $9,297     $1.34
                                                       =============================================================
--------------------------------------------------------------------------------------------------------------------
</TABLE>


                         Allied Capital Corporation II



                                       22
<PAGE>   17

                         Allied Capital Corporation II

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The 1996 distributions of $1.92 per share were comprised of cash payments and
issuance of the Company's shares pursuant to the Company's dividend
reinvestment plan in the amounts of $1.49 and $0.43, respectively. The 1995
distribution of $1.60 was comprised of cash payments and issuance of the
Company's shares pursuant to the Company's dividend reinvestment plan in the
amounts of $1.38 and $0.22, respectively. The 1994 distributions of $1.34 per
share were paid in cash. Amounts represent the total of the quarterly dividends
and the year-end extra distribution declared by the Company based on the actual
shares outstanding on the record date for each dividend paid.

The following represents a reconciliation from taxable income to income for
financial reporting purposes for the year ended December 31:

<TABLE>
<CAPTION>
----------------------------------------------------------------------
(in thousands)                           1996       1995         1994
----------------------------------------------------------------------
<S>                                   <C>        <C>          <C>
Taxable income                        $14,143    $11,206      $ 9,297
Market discount amortization            1,301         --       (1,301)
Net realized gains (losses)               367      1,267        2,991
Net unrealized appreciation
  (depreciation) on investments        (6,426)     2,762         (472)
Other                                     764       (502)          --
                                      --------------------------------
Financial statement income            $10,149    $14,733      $10,515
                                      ================================
----------------------------------------------------------------------
</TABLE>

As required by the 1940 Act, the Company is not permitted to make distributions
to shareholders unless it meets certain asset coverage requirements with
respect to money borrowed and senior securities issued. The Company was in
compliance with these requirements.

The Company's wholly owned subsidiaries annually distribute all of their
taxable income to the Company. In order to make such distributions, the
subsidiaries must meet the minimum capital requirements as set forth by the
SBA. The subsidiaries are in compliance with these requirements.

NOTE 5. BANK LOANS

The Company has a secured revolving line of credit agreement with a bank under
which it may borrow up to $25,000,000, at an interest rate equal to the thirty,
sixty or ninety day (as selected by the Company) LIBOR rate plus 1.15 percent
per annum, payable quarterly. The Company must pay a quarterly commitment fee
of 0.125 percent per annum on the average unused portion of the line of credit.
During 1996 and 1995, the Company did not use this facility and had no
borrowings outstanding under this agreement as of December 31, 1996 or 1995.
The revolving period of the line of credit agreement expires May 31, 1997.

NOTE 6. SHAREHOLDERS' EQUITY

The Company has a dividend reinvestment plan (the Plan). Shareholders of record
are automatically enrolled in the Plan, and the Plan is considered an "opt-out"
plan. The Company may instruct the stock transfer agent to buy shares in the
open market, or the Company may issue new shares. When the Company issues new
shares, the price is equal to the average of the closing sales prices reported
for the shares for the five days on which trading in the shares takes place
immediately prior to and including the dividend payment date. During 1996, the
Company issued 214,166 shares at an average price of $18.57 per share. During
1995, the Company issued 35,796 shares at an average price of $17.34 per share.

The Company has an incentive stock option plan (the ISOplan) which allows the
granting of options to the Company's officers and directors. Under the ISO plan
as amended, a maximum of 1,200,000 options may be granted at a price not less
than the market value on the date of the grant and may be exercisable over a
ten-year period.

Holders of ten percent or more of the Company's stock must exercise their
options within a five-year period.

Officers of the Company may borrow from the Company the funds necessary to
exercise vested stock options. The loans have varying terms not exceeding ten
years and bear interest at the applicable federal interest rate in effect at
the date of issue.



                         Allied Capital Corporation II

                                       
                                      23


<PAGE>   18
                         Allied Capital Corporation II

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A summary of the activity in the ISO plan is as follows:

<TABLE>
<CAPTION>
----------------------------------------------------------------------
                                 1996             1995           1994
----------------------------------------------------------------------
<S>                      <C>              <C>            <C>
Options outstanding
  at January 1                618,668          608,433        510,765
Options granted               183,073          260,888        118,168
Options exercised            (232,027)        (130,018)            --
Options canceled              (46,413)        (120,635)       (20,500)
                         ---------------------------------------------
Options outstanding
  at December 31              523,301          618,668        608,433
                         =============================================
Options available
  for grant                   201,998          338,658        478,911
Options exercisable           223,065          309,558        321,603
                         ---------------------------------------------
Option prices
  per share:
    Granted              $      17.75     $13.75-17.75   $13.75-14.25
    Exercised            $13.75-18.25     $13.75-16.50   $         --
    Canceled             $13.75-17.75     $15.00-22.75   $13.75-22.75
                         ---------------------------------------------
----------------------------------------------------------------------
</TABLE>

The Company accounts for the ISO plan as required by APB Opinion No. 25, and no
compensation cost has been recognized. Had compensation cost for the plan been
determined consistent with SFAS No. 123, the Company's net increase in net
assets resulting from operations and earnings per share would have been reduced
to the following pro forma amounts for the years ended December 31:

<TABLE>
<CAPTION>
--------------------------------------------------------
(in thousands, except per share amounts)   1996     1995
--------------------------------------------------------
<S>                                     <C>     <C>
Net increase in net assets
  resulting from operations:
    As reported                         $10,149  $14,733
    Pro forma (unaudited)               $ 9,776  $14,334
Earnings per share:
    As reported                         $  1.38  $  2.11
    Pro forma (unaudited)               $  1.33  $  2.05
--------------------------------------------------------
</TABLE>

Because the method of accounting required by SFAS No. 123 has not been applied
to options granted prior to January 1995, the resulting pro forma compensation
cost may not be representative of that to be expected in future years. The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted average
assumptions used for grants; risk-free interest rates of 6.4 and 6.0 percent
for 1996 and 1995; expected dividend yield of 9 percent for 1996 and 1995;
expected life of 5 years for all options granted in 1996 and 1995; expected
volatility of 36 percent for 1996 and 1995, respectively.

NOTE 7. COMMITMENTS AND CONTINGENCIES

The Company had commitments outstanding to various prospective and existing
portfolio companies totaling $3,120,000 at December 31, 1996.

At December 31, 1996, the Company had standby letters of credit and third party
guarantees outstanding totaling $215,000. The conditional commitments under the
letters of credit have been issued by a financial institution on behalf of the
Company to guarantee performance of a portfolio company to a third party. A
certificate of deposit of $132,000 has been used as collateral for the letters
of credit.

The Company is party to certain lawsuits in connection with its business. While
the outcome of these legal proceedings cannot at this time be predicted with
certainty, management does not expect that these proceedings will have a
material effect upon the financial condition of the Company.

NOTE 8. CONCENTRATIONS OF CREDIT RISK

The Company and its subsidiaries place their cash in financial institutions
and, at times, cash held in checking accounts may be in excess of the FDIC
insurance limit.


                         Allied Capital Corporation II


                                       24
<PAGE>   19
                         Allied Capital Corporation II

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9. QUARTERLY FINANCIAL HIGHLIGHTS (UNAUDITED)

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------
                                                                                            1996
(in thousands, except per share amounts)                                 Qtr 1       Qtr 2       Qtr 3       Qtr 4
----------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>         <C>         <C>         <C>
Total investment income                                                 $3,054      $3,079      $2,790      $3,161
Net investment income                                                   $2,298      $2,230      $2,124      $2,496
Net increase (decrease) in net assets resulting from operations         $5,949      $2,212      $2,548      $ (560)(1)
Per share                                                               $ 0.83      $ 0.30      $ 0.34      $(0.09)
----------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------
                                                                                            1995
                                                                         Qtr 1       Qtr 2       Qtr 3       Qtr 4
----------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>         <C>         <C>         <C>
Total investment income                                                 $2,932      $2,808      $3,158      $2,641
Net investment income                                                   $2,132      $1,979      $2,382      $1,857
Net increase (decrease) in net assets resulting from operations         $2,943      $5,648      $6,211      $  (69)
Per share                                                               $ 0.42      $ 0.81      $ 0.89      $(0.01)
----------------------------------------------------------------------------------------------------------------------
</TABLE>

(1) The net decrease in net assets resulting from operations for the fourth
quarter of 1996 is primarily due to the depreciation of two public company
investments of $2.4 million and one private company investment of $1.4 million
from their value at September 30, 1996.



                         Allied Capital Corporation II


                                       25
<PAGE>   20
                       REPORT OF INDEPENDENT ACCOUNTANTS

The Board of Directors and Shareholders
Allied Capital Corporation II

We have audited the consolidated balance sheet of Allied Capital Corporation II
and its wholly owned subsidiaries as of December 31, 1996 and 1995, including
the consolidated statement of loans and investments as of December 31, 1996,
and the related consolidated statements of operations, changes in net assets
and cash flows for each of the three years in the period ended December 31,
1996, and the selected per share data presented as financial highlights for
each of the five years in the period ended December 31, 1996.  These financial
statements and per share data are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and per share data based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and per share data
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. Our procedures included the examination or confirmation of
securities owned at December 31, 1996 and 1995. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included the examination or
confirmation of securities owned at December 31, 1996 and 1995. An audit also
includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated financial statements and selected per share
data referred to above present fairly, in all material respects, the financial
position of Allied Capital Corporation II and its wholly owned subsidiaries as
of December 31, 1996 and 1995, and the consolidated results of their
operations, changes in net assets and cash flows for each of the three years in
the period ended December 31, 1996, and the selected per share data for each of
the five years in the period ended December 31, 1996 in conformity with
generally accepted accounting principles.

As explained in Note 1, the consolidated financial statements include
securities valued at $86,266,000 as of December 31, 1996 and $99,207,000 as of
December 31, 1995, (81 percent and 93 percent, respectively, of total assets)
whose values have been estimated by the Board of Directors in the absence of
readily ascertainable market values. We have reviewed the procedures used by
the Board of Directors in arriving at its estimate of value of such securities
and have inspected underlying documentation, and, in the circumstances, we
believe the procedures are reasonable and the documentation appropriate.
However, because of the inherent uncertainty of valuation, those estimated
values may differ significantly from the values that would have been used had a
ready market for the securities existed, and the differences could be material.


                                                  /s/ Matthews, Carter and Boyce

McLean, Virginia
February 4, 1997


                         Allied Capital Corporation II


                                       26
<PAGE>   21
                         Allied Capital Corporation II

                            DIRECTORS AND OFFICERS*

<TABLE>
<CAPTION>
DIRECTORS                                        OFFICERS                                   
<S>                                              <C>                                        <C>
William L. Walton(1)                             William L. Walton                          Kelly A. Anderson                     
Chairman of the Board &                          Chairman of the Board,                     Vice President, Corporate Controller &
Chief Executive Officer                          Chief Executive Officer & President        Assistant Treasurer                   
                                                                                                                                  
David Gladstone                                  Jon A. DeLuca                              Christina L. DelDonna                 
Vice Chairman                                    Executive Vice President, Treasurer &      Vice President & Assistant Controller 
                                                 Chief Financial Officer                                                          
John D. Firestone(2,3)                                                                      Robert M. Monk                        
Partner, Secor Group                             Katherine C. Marien                        Vice President                        
                                                 Executive Vice President                                                         
Lawrence I. Hebert(1,3)                                                                     Penni F. Roll                         
Director & President,                            John M. Scheurer                           Vice President, Controller &          
Perpetual Corporation                            Executive Vice President                   Assistant Treasurer                   
                                                                                                                                  
John I. Leahy(2)                                 George Stelljes III                        Suzanne V. Sparrow                    
President, Management &                          Executive Vice President                   Vice President, Investor Relations &  
Marketing Associates, Inc.                                                                  Assistant Secretary                   
                                                 Joan M. Sweeney                                                                  
John D. Reilly(1,3)                              Executive Vice President                   Gay S. Truscott                       
President, Reilly Investment Corporation                                                    Vice President                        
                                                 Thomas H. Westbrook                                                              
George C. Williams                               Executive Vice President                   Peter C. Fisher                       
Financial Consultant                                                                        Assistant Vice President              
                                                 G. Cabell Williams III                                                           
Smith T. Wood(1,2)                               Executive Vice President                   Kristine M. Lansing                   
Director & President, CyberSERV, Inc.                                                       Assistant Vice President &            
                                                 Tricia B. Daniels                          Assistant Secretary                   
(1) Executive Committee                          Senior Vice President & Secretary                                                
(2) Audit Committee                                                                         Donna B. Natale                       
(3) Compensation Committee                       Richard E. Fearon, Jr.                     Assistant Vice President &            
                                                 Senior Vice President                      Assistant Secretary                   
*As of March 1, 1997                                                                                                              
                                                 Philip A. McNeill                          Arthur S. Cooper                      
                                                 Senior Vice President                      Assistant Secretary                   
                                                                                                                                  
                                                 Carr T. Preston                            Thomas R. Salley III                  
                                                 Senior Vice President                      Assistant Secretary                   
</TABLE>


           QUARTERLY STOCK PRICE AND DISTRIBUTIONS TO SHAREHOLDERS

The following table sets forth the high and low bid prices of the Company's
common stock by calendar quarter during 1996 and 1995 and the distributions
paid per share. The quotations represent interdealer quotations and do not
include markups, markdowns or commissions and may not necessarily represent
actual transactions.

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------
                                                       1996                                 1995
                                                            DISTRIBUTIONS                        Distributions
                                         HIGH       LOW       PER SHARE      High        Low       Per Share
--------------------------------------------------------------------------------------------------------------
<S>                                     <C>       <C>           <C>         <C>        <C>           <C>
First Quarter                           $18.50    $16.25        $0.33       $14.75     $13.75        $0.25
Second Quarter                          $18.50    $15.50        $0.35       $16.25     $14.00        $0.27
Third Quarter                           $20.25    $17.25        $0.38       $16.25     $15.00        $0.29
Fourth Quarter                          $21.88    $18.75        $0.41       $19.00     $15.75        $0.31
Annual Extra Distribution                                       $0.45                                $0.48
                                                                -----                                -----
  Total Distribution                                            $1.92                                $1.60
                                                                =====                                =====
--------------------------------------------------------------------------------------------------------------
</TABLE>


Designed by Curran & Connors, Inc.