**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

(Mark One)

 

| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE                            SECURITIES EXCHANGE ACT OF 1934

                              |
|---|--------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | For the quarterly period endedSeptember 30, 2007 |
|--------|--------------------------------------------------|

OR

| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE                            SECURITIES EXCHANGE ACT OF 1934 |
|---|---------------------------------------------------------------------------------------------------------------------|

 

For the transition period from _________________ to            ________________

 

Commission file number0-28366

 

| **Norwood Financial Corp.**                                                       |
|-----------------------------------------------------------------------------------|
| (Exact name of Registrant as specified in its                            charter) |

 

| Pennsylvania                                                    |   | 23-2828306                           |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of

Incorporation or organization) |   | (I.R.S. Employer Identification No.) |

 

| 717 Main Street, Honesdale, Pennsylvania |   | 18431      |   |
|------------------------------------------|--------|------------|--------|
| (Address of principal executive offices) |   | (Zip Code) |   |

 

| (570) 253-1455                                                                        |
|---------------------------------------------------------------------------------------|
| (Registrant’s telephone number, including area                            code) |

 

| NA                                                                                                             |
|----------------------------------------------------------------------------------------------------------------|
| (Former name, former address and former fiscal year, if                            changed since last report)) |

 

Indicate by check (x) whether the registrant (1) has filed all reports            required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934            during the preceding 12 months (or for such shorter period that the registrant was            required to file such reports), and (2) has been subject to such filing requirements            for the past 90 days. Yesx      No o

 

Indicate by check mark whether the registrant is a large accelerated            filer, an accelerated filer, or non-accelerated filer. See definition of            “accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange            Act. (Check one):

 

| Large accelerated filer                            o | Accelerated filer                            o | Non-accelerated filerx |
|------------------------------------------------------|------------------------------------------------|------------------------|

 

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

 

Indicate the number of shares outstanding of each of the issuer’s            classes of common stock, as of the latest practicable date.

 

| Class                                   |   | Outstanding as of November 13, 2007 |
|-----------------------------------------|--------|-------------------------------------|
| Common stock, par value $0.10 per share |   | 2,767,959                           |

 

 

1

 

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**NORWOOD FINANCIAL CORP.**

**FORM 10-Q**

**FOR THE QUARTER ENDED SEPTEMBER 30, 2007**

**INDEX**

 

 

|                                           |                                                                                                                                              |  

Page   

Number |
|------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------|
| PART I -

                                | CONSOLIDATED FINANCIAL INFORMATION OF NORWOOD

FINANCIAL CORP.                                                                                    |                                   |
|                                           |                                                                                                                                              |                                   |
| Item 1.                                        | Financial Statements                                                                                                                              | 3                                      |
| Item                            2.             | Management’s                            Discussion and Analysis of Financial Condition and Results of                            Operations | 13                                     |
| Item                            3.             | Quantitative and Qualitative Disclosures about Market                            Risk                                                             | 29                                     |
| Item                            4.             | Controls and Procedures                                                                                                                           | 30                                     |
| Item                            4T.            | Controls and Procedures                                                                                                                           | 30                                     |
|                                           |                                                                                                                                              |                                   |
| PART II -                                      | OTHER INFORMATION                                                                                                                                 |                                   |
|                                           |                                                                                                                                              |                                   |
| Item 1.                                        | Legal Proceedings                                                                                                                                 | 31                                     |
| Item                            1A.            | Risk                            Factors                                                                                                           | 31                                     |
| Item                            2.             | Unregistered                            Sales of Equity Securities and Use of Proceeds                                                            | 31                                     |
| Item                            3.             | Defaults upon                            Senior Securities                                                                                        | 31                                     |
| Item                            4.             | Submission                            of Matters to a Vote of Security Holders                                                                    | 32                                     |
| Item                            5.             | Other                            Information                                                                                                      | 32                                     |
| Item                            6.             | Exhibits                                                                                                                                          | 32                                     |
|                                           |                                                                                                                                              |                                   |
| Signatures

                              |                                                                                                                                              | 34                                     |

 

 

 

 

 

 

2

 

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**PART I. FINANCIAL INFORMATION**

**Item 1. Financial            Statements**

NORWOOD FINANCIAL CORP.

Consolidated Balance Sheets (unaudited)

 

| (dollars in thousands, except per share data)                                                             |   | **September 30,** |    |   | **December 31,** |   |
|-----------------------------------------------------------------------------------------------------------|--------|-------------------|---------|--------|------------------|--------|
|                                                                                                      |   | **2007**          |    |   | **2006**         |   |
| ASSETS                                                                                                    |   |              |    |   |             |   |   |   |
| Cash and due from banks                                                                                   |   | $                 | 8,656   |   |             | $      | 9,450 |   |
| Interest bearing deposits with banks                                                                      |   |              | 218     |   |             |   | 67 |   |
| Cash and cash equivalents                                                                                 |   |              | 8,874   |   |             |   | 9,517 |   |
|                                                                                                      |   |              |    |   |             |   |   |   |
| Securities available for sale                                                                             |   |              | 118,736 |   |             |   | 112,912 |   |
| Securities held to maturity, fair value 2007:

$723, 2006: $971                                           |   |              | 705     |   |             |   | 954 |   |
| Loans receivable (net of unearned income)                                                                 |   |              | 328,582 |   |             |   | 315,567 |   |
| Less: Allowance for loan losses                                                                           |   |              | 3,979   |   |             |   | 3,828 |   |
| Net loans receivable                                                                                      |   |              | 324,603 |   |             |   | 311,739 |   |
| Investment in FHLB Stock, at cost                                                                         |   |              | 1,989   |   |             |   | 1,687 |   |
| Bank premises and equipment, net                                                                          |   |              | 5,764   |   |             |   | 6,020 |   |
| Bank owned life insurance                                                                                 |   |              | 7,694   |   |             |   | 7,479 |   |
| Accrued interest receivable                                                                               |   |              | 2,417   |   |             |   | 2,129 |   |
| Other assets                                                                                              |   |              | 2,084   |   |             |   | 1,919 |   |
| TOTAL ASSETS                                                                                              |   | $                 | 472,866 |   |             | $      | 454,356 |   |
|                                                                                                      |   |              |    |   |             |   |   |   |
| LIABILITIES                                                                                               |   |              |    |   |             |   |   |   |
| Deposits:                                                                                                 |   |              |    |   |             |   |   |   |
| Non-interest bearing demand                                                                               |   | $                 | 60,880  |   |             | $      | 53,856 |   |
| Interest bearing                                                                                          |   |              | 306,673 |   |             |   | 304,247 |   |
| Total deposits                                                                                            |   |              | 367,553 |   |             |   | 358,103 |   |
| Short-term borrowings                                                                                     |   |              | 22,628  |   |             |   | 22,736 |   |
| Other borrowings                                                                                          |   |              | 23,000  |   |             |   | 13,000 |   |
| Accrued interest payable                                                                                  |   |              | 2,590   |   |             |   | 2,894 |   |
| Other liabilities                                                                                         |   |              | 2,375   |   |             |   | 5,392 |   |
| TOTAL LIABILITIES                                                                                         |   |              | 418,146 |   |             |   | 402,125 |   |
|                                                                                                      |   |              |    |   |             |   |   |   |
| STOCKHOLDERS’ EQUITY                                                                                |   |              |    |   |             |   |   |   |
| Common stock, $.10 par value, authorized                            10,000,000

shares, issued: 2,840,872 |   |              | 284     |   |             |   | 284 |   |
| Surplus                                                                                                   |   |              | 10,203  |   |             |   | 10,149 |   |
| Retained earnings                                                                                         |   |              | 46,046  |   |             |   | 43,125 |   |
| Treasury stock at cost: 2007: 72,913 shares,                            2006:

  43,721 shares       |   |              | (2,237  | )      |             |   | (1,283 | ) |
| Accumulated other comprehensive income (loss)                                                             |   |              | 424     |   |             |   | (44 | ) |
| TOTAL STOCKHOLDERS’ EQUITY                                                                          |   |              | 54,720  |   |             |   | 52,231 |   |
| TOTAL LIABILITIES AND

STOCKHOLDERS’ EQUITY                                                         |   | $                 | 472,866 |   |             | $      | 454,356 |   |

 

See            accompanying notes to the unaudited consolidated financial statements

 

3

 

----

NORWOOD FINANCIAL CORP.

Consolidated Statements of Income (unaudited)

 

| (dollars in thousands, except per share data)                         | **Three Months Ended** |   | **Nine Months Ended** |   |
|-----------------------------------------------------------------------|------------------------|--------|-----------------------|--------|
|                                                                  | **September 30,**      |   | **September 30,**     |   |
|                                                                  | **2007**               |   | **2006**              |   | **2007** |   | **2006** |   |
| INTEREST INCOME                                                       |                   |   |                  |   |   |   |   |   |   |   |   |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| Loans receivable, including                            fees           | $                      | 6,054  |                  | $      | 5,506 |   | $ | 17,772 |   | $ | 15,651 |   |
| Securities                                                            |                   | 1,370  |                  |   | 1,105 |   |   | 3,866 |   |   | 3,221 |   |
| Other                                                                 |                   | 33     |                  |   | 36 |   |   | 144 |   |   | 121 |   |
| Total interest income                                                 |                   | 7,457  |                  |   | 6,647 |   |   | 21,782 |   |   | 18,993 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| INTEREST EXPENSE                                                      |                   |   |                  |   |   |   |   |   |   |   |   |   |
| Deposits                                                              |                   | 2,489  |                  |   | 2,032 |   |   | 7,449 |   |   | 5,360 |   |
| Short-term borrowings                                                 |                   | 195    |                  |   | 235 |   |   | 656 |   |   | 585 |   |
| Other borrowings                                                      |                   | 281    |                  |   | 278 |   |   | 808 |   |   | 991 |   |
| Total interest expense                                                |                   | 2,965  |                  |   | 2,545 |   |   | 8,913 |   |   | 6,936 |   |
| NET INTEREST INCOME                                                   |                   | 4,492  |                  |   | 4,102 |   |   | 12,869 |   |   | 12,057 |   |
| PROVISION FOR LOAN LOSSES                                             |                   | 90     |                  |   | 45 |   |   | 195 |   |   | 170 |   |
| NET INTEREST INCOME AFTERPROVSION FOR LOAN LOSSES                     |                   | 4,402  |                  |   | 4,057 |   |   | 12,674 |   |   | 11,887 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| OTHER INCOME                                                          |                   |   |                  |   |   |   |   |   |   |   |   |   |
| Service charges and fees                                              |                   | 635    |                  |   | 616 |   |   | 1,876 |   |   | 1,850 |   |
| Income from fiduciary activities                                      |                   | 117    |                  |   | 89 |   |   | 335 |   |   | 261 |   |
| Net realized gains on sales of securities                             |                   | --     |                  |   | 45 |   |   | 15 |   |   | 66 |   |
| Gain on sale of loans and servicing                            rights |                   | 8      |                  |   | 3 |   |   | 16 |   |   | 110 |   |
| Other                                                                 |                   | 153    |                  |   | 141 |   |   | 422 |   |   | 434 |   |
| Total other income                                                    |                   | 913    |                  |   | 894 |   |   | 2,664 |   |   | 2,721 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| OTHER EXPENSES                                                        |                   |   |                  |   |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                                        |                   | 1,432  |                  |   | 1,482 |   |   | 4,367 |   |   | 4,344 |   |
| Occupancy, furniture & equipment, net                             |                   | 400    |                  |   | 329 |   |   | 1,231 |   |   | 1,078 |   |
| Data processing related                                               |                   | 173    |                  |   | 185 |   |   | 515 |   |   | 511 |   |
| Taxes, other than income                                              |                   | 54     |                  |   | 110 |   |   | 293 |   |   | 334 |   |
| Professional fees                                                     |                   | 75     |                  |   | 62 |   |   | 258 |   |   | 279 |   |
| Other                                                                 |                   | 653    |                  |   | 562 |   |   | 1,831 |   |   | 1,791 |   |
| Total other expenses                                                  |                   | 2,787  |                  |   | 2,730 |   |   | 8,495 |   |   | 8,337 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| INCOME BEFORE INCOME TAXES                                            |                   | 2,528  |                  |   | 2,221 |   |   | 6,843 |   |   | 6,271 |   |
| INCOME TAX EXPENSE                                                    |                   | 722    |                  |   | 699 |   |   | 2,004 |   |   | 1,940 |   |
| NET INCOME                                                            | $                      | 1,806  |                  | $      | 1,522 |   | $ | 4,839 |   | $ | 4,331 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| BASIC EARNINGS PER SHARE                                              | $                      | 0.65   |                  | $      | 0.54 |   | $ | 1.74 |   | $ | 1.55 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |
| DILUTED EARNINGS PER SHARE                                            | $                      | 0.64   |                  | $      | 0.53 |   | $ | 1.71 |   | $ | 1.52 |   |
|                                                                  |                   |   |                  |   |   |   |   |   |   |   |   |   |

 

See            accompanying notes to the unaudited consolidated financial statements

 

4

 

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NORWOOD FINANCIAL CORP.

Consolidated Statements of Changes in Stockholders’ Equity            (unaudited)

 

 

| (dollars in thousands, except per share data)

                             

                                                   | **Number of shares issued** |   |   | **Common Stock** |   | **Surplus** |   |   | **Retained Earnings** |   | **Treasury Stock** |   | **Unearned ESOP Shares** |   | **Accumulated Other Comprehensive (Loss)                            Income** |   | **Total** |
|--------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------|--------|--------|------------------|--------|-------------|--------|--------|-----------------------|--------|--------------------|--------|--------------------------|--------|------------------------------------------------------------------------------|--------|-----------|
|                                                                                                                                       |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance December 31, 2005                                                                                                                  | 2,705,715                   |   |   | $                | 270    |        |   | $      | 5,648                 |   |               |   | $                        | 43,722 |                                                                         |   | $         | (633 | ) |   | $ | (127 | ) |   | $ | (772 | ) |   | $ | 48,108 |   |
| Comprehensive Income:                                                                                                                      |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Income                                                                                                                                 |                        |   |   |             |   |        |   |   |                  |   |               |   |                     | 4,331  |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   | 4,331 |   |
| Change in unrealized losseson securities available for sale, net of                            reclassification adjustment and tax effects |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   | 483 |   |   |   | 483 |   |
|                                                                                                                                       |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total comprehensive income                                                                                                                 |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   | 4,814 |   |
|                                                                                                                                       |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash dividends declared, $.62 per share                                                                                                    |                        |   |   |             |   |        |   |   |                  |   |               |   |                     | (1,727 | )                                                                            |   |      |   |   |   |   |   |   |   |   |   |   |   |   | (1,727 | ) |
| 5% Stock dividend                                                                                                                          | 135,157                     |   |   |             | 14     |        |   |   | 4,121                 |   |               |   |                     | (4,139 | )                                                                            |   |      |   |   |   |   |   |   |   |   |   |   |   |   | (4 | ) |
| Acquisition of treasury stock                                                                                                              |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      | (671 | ) |   |   |   |   |   |   |   |   |   |   | (671 | ) |
| Stock options exercised                                                                                                                    |                        |   |   |             |   |        |   |   | (26                   | )      |               |   |                     |   |                                                                         |   |      | 58 |   |   |   |   |   |   |   |   |   |   |   | 32 |   |
| Tax benefit of stock options exercised                                                                                                     |                        |   |   |             |   |        |   |   | 1                     |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   | 1 |   |
| Compensation expense related to stock options                                                                                              |                        |   |   |             |   |        |   |   | 85                    |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   | 85 |   |
| Release of earned ESOP shares                                                                                                              |                        |   |   |             |   |        |   |   | 294                   |   |               |   |                     |   |                                                                         |   |      |   |   |   |   | 127 |   |   |   |   |   |   |   | 421 |   |
| Balance, September 30, 2006                                                                                                                | 2,840,872                   |   |   | $                | 284    |        |   | $      | 10,123                |   |               |   | $                        | 42,187 |                                                                         |   | $         | (1,246 | ) |   | $ | - |   |   | $ | (289 | ) |   | $ | 51,059 |   |
|                                                                                                                                       |                        |   |   |             |   |        |   |   |                  |   |               |   |                     |   |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

 

| (dollars in thousands, except per share data)

                             

                                                  | **Number of shares issued** |   |   | **Common Stock** |   | **Surplus** |   |   | **Retained Earnings** |   | **Treasury                            Stock** | **Accumulated Other Comprehensive (Loss)                            Income** |   | **Total** |
|-------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------|--------|--------|------------------|--------|-------------|--------|--------|-----------------------|--------|-----------------------------------------------|------------------------------------------------------------------------------|--------|-----------|
|                                                                                                                                      |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance December 31, 2006                                                                                                                 | 2,840,872                   |   |   | $                | 284    |        |   | $      | 10,149                |   |                                          |                                                                         | $      | 43,125    |   |   | $ | (1,283 | ) | $ | (44 | ) |   | $ | 52,231 |   |
| Comprehensive Income:                                                                                                                     |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Income                                                                                                                                |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   | 4,839     |   |   |   |   |   |   |   |   |   |   | 4,839 |   |
| Change in unrealized gainson securities available for sale, net of                            reclassification adjustment and tax effects |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   |   |   |   | 468 |   |   |   | 468 |   |
|                                                                                                                                      |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Total comprehensive income                                                                                                                |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   | 5,307 |   |
|                                                                                                                                      |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash dividends declared, $.69 per share                                                                                                   |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   | (1,918    | ) |   |   |   |   |   |   |   |   |   | (1,918 | ) |
| Acquisition of treasury stock                                                                                                             |                        |   |   |             |   |        |   |   |                  |   |                                          |                                                                         |   |      |   |   |   | (1,385 | ) |   |   |   |   |   | (1,385 | ) |
| Stock options exercised                                                                                                                   |                        |   |   |             |   |        |   |   | (243                  | )      |                                          |                                                                         |   |      |   |   |   | 431 |   |   |   |   |   |   | 188 |   |
| Tax benefit of stock options exercised                                                                                                    |                        |   |   |             |   |        |   |   | 98                    |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   | 98 |   |
| Compensation expense related to stock options                                                                                             |                        |   |   |             |   |        |   |   | 199                   |   |                                          |                                                                         |   |      |   |   |   |   |   |   |   |   |   |   | 199 |   |
| Balance September 30, 2007                                                                                                                | 2,840,872                   |   |   | $                | 284    |        |   | $      | 10,203                |   |                                          |                                                                         | $      | 46,046    |   |   | $ | (2,237 | ) | $ | 424 |   |   | $ | 54,720 |   |

 

See            accompanying notes to the unaudited consolidated financial statements

 

5

 

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NORWOOD            FINANCIAL CORP.

Consolidated Statements of Cash Flows (unaudited)

 

| (dollars in thousands)                                                                                       |   | **Nine Months Ended                            September 30,** |
|--------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------|
|                                                                                                         |   | **2007**                                                       |   |   |   | **2006** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES                                                                         |   |                                                           |   |   |   |   |   |   |   |
| Net Income                                                                                                   |   | $                                                              | 4,839 |   |   |   | $ | 4,331 |   |
| Adjustments to reconcile net income to net cash provided                            by operating activities: |   |                                                           |   |   |   |   |   |   |   |
| Provision for loan losses                                                                                    |   |                                                           | 195 |   |   |   |   | 170 |   |
| Depreciation                                                                                                 |   |                                                           | 425 |   |   |   |   | 372 |   |
| Amortization of intangible assets                                                                            |   |                                                           | 39 |   |   |   |   | 39 |   |
| Deferred income taxes                                                                                        |   |                                                           | 207 |   |   |   |   | 145 |   |
| Net amortization of securities premiums and                            discounts                             |   |                                                           | 101 |   |   |   |   | 243 |   |
| Net realized gain on sales of securities                                                                     |   |                                                           | (15 | ) |   |   |   | (66 | ) |
| Earnings on life insurance                            policies                                               |   |                                                           | (215 | ) |   |   |   | (197 | ) |
| Net gain on sale of mortgage loans and servicing                            rights                           |   |                                                           | (16 | ) |   |   |   | (110 | ) |
| Gain on sale of bank premises and                            equipment and foreclosed real estate            |   |                                                           | — |   |   |   |   | (5 | ) |
| Mortgage loans originated for sale                                                                           |   |                                                           | (801 | ) |   |   |   | (572 | ) |
| Proceeds from sale of mortgage loans and servicing                            rights                         |   |                                                           | 817 |   |   |   |   | 682 |   |
| Release of ESOP shares                                                                                       |   |                                                           | — |   |   |   |   | 421 |   |
| Compensation expense related to stock                            options                                     |   |                                                           | 199 |   |   |   |   | 85 |   |
| Decrease (increase) in accrued interest receivable and                            other assets               |   |                                                           | (651) |   |   |   |   | 613 |   |
| Increase (decrease) in accrued interest payable and                            other liabilities             |   |                                                           | (3,549 | ) |   |   |   | 676 |   |
| Net cash provided by operating activities                                                                    |   |                                                           | 1,575 |   |   |   |   | 6,828 |   |
|                                                                                                         |   |                                                           |   |   |   |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES                                                                         |   |                                                           |   |   |   |   |   |   |   |
| Securities available for sale:                                                                               |   |                                                           |   |   |   |   |   |   |   |
| Proceeds from sales                                                                                          |   |                                                           | 74 |   |   |   |   | 96 |   |
| Proceeds from maturities and principal reductions on                            mortgage-backed securities   |   |                                                           | 37,761 |   |   |   |   | 20,616 |   |
| Purchases                                                                                                    |   |                                                           | (43,046 | ) |   |   |   | (16,750 | ) |
| Securities held to maturity- proceeds from                            calls                                  |   |                                                           | 250 |   |   |   |   | 505 |   |
| Net increase in investment in FHLB stock                                                                     |   |                                                           | (302 | ) |   |   |   | (14 | ) |
| Net increase in loans                                                                                        |   |                                                           | (13,107 | ) |   |   |   | (22,910 | ) |
| Purchase of bank premises and equipment                                                                      |   |                                                           | (169 | ) |   |   |   | (468 | ) |
| Proceeds from sale of bank premises and equipment and                            foreclosed real estate      |   |                                                           | — |   |   |   |   | 29 |   |
| Net cash used in investing activities                                                                        |   |                                                           | (18,539 | ) |   |   |   | (18,896 | ) |
|                                                                                                         |   |                                                           |   |   |   |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES                                                                         |   |                                                           |   |   |   |   |   |   |   |
| Net increase in deposits                                                                                     |   |                                                           | 9,450 |   |   |   |   | 24,003 |   |
| Net decrease in short-term borrowings                                                                        |   |                                                           | (108 | ) |   |   |   | (3,294 | ) |
| Proceeds from (repayments of) other                            borrowings                                    |   |                                                           | 10,000 |   |   |   |   | (5,000) |   |
| Tax benefit of stock options exercised                                                                       |   |                                                           | 98 |   |   |   |   | 1 |   |
| Stock options exercised                                                                                      |   |                                                           | 188 |   |   |   |   | 32 |   |
| Acquisition of treasury stock                                                                                |   |                                                           | (1,385 | ) |   |   |   | (671 | ) |
| Cash dividends paid                                                                                          |   |                                                           | (1,922 | ) |   |   |   | (1,704 | ) |
| Net cash provided by financing activities                                                                    |   |                                                           | 16,321 |   |   |   |   | 13,366 |   |
| Increase (decrease) in cash and cash                            equivalents                                  |   |                                                           | (643) |   |   |   |   | 1,298 |   |
|                                                                                                         |   |                                                           |   |   |   |   |   |   |   |
| CASH AND CASH EQUIVALENTS, BEGINNING OF                            PERIOD                                    |   |                                                           | 9,517 |   |   |   |   | 9,816 |   |
| CASH AND CASH EQUIVALENTS, END OF PERIOD                                                                     |   | $                                                              | 8,874 |   |   |   | $ | 11,114 |   |

 

See            accompanying notes to the unaudited consolidated financial statements

6

 

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**Notes to Unaudited Consolidated Financial            Statements**

**1.****Basis of            Presentation**

 

The consolidated financial statements include the accounts of Norwood            Financial Corp. (Company) and its wholly-owned subsidiary, Wayne Bank (Bank) and the            Bank’s wholly-owned subsidiaries, WCB Realty Corp., Norwood Investment Corp. and            WTRO Properties. All significant intercompany transactions have been eliminated in            consolidation.

             

The accompanying unaudited consolidated financial statements have been            prepared in conformity with generally accepted accounting principles for interim            financial statements and with instructions to Form 10-Q. Accordingly, they do not            include all of the information and footnotes required by generally accepted principles            for complete financial statements. In preparing the financial statements, management is            required to make estimates and assumptions that affect the reported amounts of assets            and liabilities as of the date of the balance sheet and revenues and expenses for the            period. Actual results could differ from those estimates. The financial statements            reflect, in the opinion of management all normal, recurring adjustments necessary to            present fairly the results of operations and financial position of the Company. The            operating results for the three and nine month periods ended September 30, 2007 are not            necessarily indicative of the results that may be expected for the year ending December            31, 2007 or any other future interim period.

             

These statements should be read in conjunction with the consolidated            financial statements and related notes which are incorporated by reference in the            Company’s Annual Report on Form 10-K for the year-ended December 31,            2006.

 

**2.****Earnings Per            Share**

 

Basic earnings per share represents income available to common            stockholders divided by the weighted average number of common shares outstanding during            the period. Diluted earnings per share reflects additional common shares that would            have been outstanding if dilutive potential common shares had been issued, as well as            any adjustment to income that would result from the assumed issuance. Potential common            shares that may be issued by the Company relate solely to outstanding stock options and            are determined using the treasury stock method.

 

The following table sets forth the weighted average number of common            shares used in the computations of basic and diluted earnings per share:

 

| (in thousands)                                                             |   | **Three Months Ended**

**September 30,** |   |   | **Nine Months Ended**

**September 30,** |   |
|----------------------------------------------------------------------------|--------|-------------------------------------------|--------|--------|------------------------------------------|--------|
|                                                                       |   | **2007**                                  |   |   | **2006**                                 |   |   | **2007** |   |   | **2006** |   |
|                                                                       |   |                                      |   |   |                                     |   |   |   |   |   |   |   |
| Basic EPS weighted average shares outstanding                              |   | 2,773                                     |   |   | 2,794                                    |   |   | 2,783 |   |   | 2,794 |   |
| Dilutive effect of stock options                                           |   | 46                                        |   |   | 59                                       |   |   | 52 |   |   | 58 |   |
| Diluted EPS weighted average shares                            outstanding |   | 2,819                                     |   |   | 2,853                                    |   |   | 2,835 |   |   | 2,852 |   |
|                                                                       |   |                                      |   |   |                                     |   |   |   |   |   |   |   |

 

 

7

 

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**3.****Stock-Based            Compensation**

             

In December 2004, the Financial Accounting Standards Board (FASB) issued            Statement No. 123(R), “Share-Based Payment.” Statement No. 123(R) replaces            Statement No. 123, “Accounting for Stock-Based Compensation,” and            supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”            Statement No. 123(R) requires that the fair value of share-based payment transactions            be recognized as compensation costs in the financial statements over the period that an            employee provides service in exchange for the award. The fair value of the share-based            payments is estimated using the Black-Scholes option-pricing model. The Company adopted            Statement No. 123(R) effective January 1, 2006, using the modified-prospective            transition method. Under the modified prospective method, companies are required to            record compensation cost for new and modified awards over the related vesting period of            such awards and record compensation cost prospectively for the unvested portion, at the            date of adoption, of previously issued and outstanding awards over the remaining            vesting period of such awards. No change to prior periods presented is permitted under            the modified prospective method. All outstanding options as of December 31, 2005 were            fully vested. The Company’s shareholders approved the Norwood Financial Corp 2006            Stock Option Plan at the annual meeting on April 25, 2006 and the Company awarded            47,700 options in 2006, all of which have a twelve month vesting period. As of            September 30, 2007, there was approximately $48,000 of total unrecognized compensation            cost related to nonvested options under the plan, which will be fully amortized by            December 31, 2007.

 

No stock options were granted during the nine months ended September 30,            2007.   A summary of stock options from all plans, adjusted for stock            dividends declared, is shown below.

 

|                               | **Options** |   |   | **Weighted Average Exercise Price**

**Per Share** |   | **Weighted Average Remaining Contractual                            Term** |   | **Aggregate Intrinsic Value ($000)** |   |
|------------------------------------|-------------|--------|--------|----------------------------------------------------|--------|----------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                               |        |   |   |                                               |   |                                                                       |   |                                 |   |   |   |   |   |
| Outstanding at January 1, 2007     | 183,645     |   |   | $                                                  | 21.81  |                                                                       |   | 6.0                                  | Yrs.   |   | $ | 1,780 |   |
| Exercised                          | (14,384     | )      |   |                                               | 12.91  |                                                                       |   |                                 |   |   |   |   |   |
| Outstanding at September 30, 2007  | 169,261     |   |   | $                                                  | 22.57  |                                                                       |   | 5.8                                  |   |   | $ | 1,723 |   |
| Exerciseable at September 30, 2007 | 146,761     |   |   | $                                                  | 21.19  |                                                                       |   | 6.0                                  |   |   | $ | 1,697 |   |
|                               |        |   |   |                                               |   |                                                                       |   |                                 |   |   |   |   |   |

 

Intrinsic value represents the amount by which the market price of the            stock on the measurement date exceeded the exercise price of the option. The intrinsic            value of options exercised during the nine months ended September 30, 2007 was            $284,000, cash received from such exercises was $188,000 and the tax benefit recognized            was $98,000.

             

**4.****New Borrowings**

 

In January 2007 the company borrowed $10 million in the form of a            convertible note from the Federal Home Loan Bank of Pittsburgh (FHLB). The note has a            ten year term and has a fixed interest rate of 4.71% for three years. The convertible            note contains an option that allows the FHLB, at quarterly intervals to change the note            to an adjustable-rate advance at three-month LIBOR plus 16 basis points. If the note is            converted, the Company has the option to put the funds back to the FHLB without            penalty.

 

8

 

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**5.****Cash Flow            Information**

 

For the purposes of reporting cash flows, cash and cash equivalents            include cash on hand, amounts due from banks, interest-bearing deposits with banks and            federal funds sold, all of which mature within 90 days.

 

Cash payments for interest for the nine months ended September 30, 2007            and 2006 were $9,218,000 and $6,340,000 respectively. Cash payments for income taxes in            2007 were $1,966,000 compared to $1,873,000 in 2006. Non-cash investing activities for            2007 and 2006 included foreclosed mortgage loans and repossession of other assets of            $47,000 and $111,000, respectively.

 

**6.****Comprehensive            Income**

 

Accounting principles generally accepted in the United States of America            require that recognized revenue, expenses, gains and losses be included in net income.            Although certain changes in assets and liabilities such as unrealized gains and losses            on available for sale securities, are reported as a separate component of the equity            section of the consolidated balance sheet, such items, along with net income, are            components of comprehensive income. The components of other comprehensive income and            related tax effects are as follows.

 

 

| (in thousands)                                                                       | **Three Months Ended September 30,** |   |   | **Nine Months****Ended                            September 30,** |
|--------------------------------------------------------------------------------------|--------------------------------------|--------|--------|-------------------------------------------------------------------|
|                                                                                 | **2007**                             |   |   | **2006**                                                          |   |   | **2007** |   |   | **2006** |
|                                                                                 |                                 |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains on available for sale                            securities | $                                    | 1,123  |   |                                                              |   | $ | 1,285 |   |   |   | $ | 715 |   |   |   | $ | 799 |   |
|                                                                                 |                                 |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Reclassification adjustment for gainsrealized in net income                          |                                 | -      |   |                                                              |   |   | (45) |   |   |   |   | (15 | ) |   |   |   | (66 | ) |
|                                                                                 |                                 |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net unrealized gains                                                                 |                                 | 1,123  |   |                                                              |   |   | 1,240 |   |   |   |   | 700 |   |   |   |   | 733 |   |
| Income tax                                                                           |                                 | 380    |   |                                                              |   |   | 423 |   |   |   |   | 232 |   |   |   |   | 250 |   |
| Other comprehensive income                                                           | $                                    | 743    |   |                                                              |   | $ | 817 |   |   |   | $ | 468 |   |   |   | $ | 483 |   |
|                                                                                 |                                 |   |   |                                                              |   |   |   |   |   |   |   |   |   |   |   |   |   |   |

 

**7.****Off-Balance Sheet Financial            Instruments and Guarantees**

 

The Bank is a party to financial instruments with off-balance-sheet risk            in the normal course of business to meet the financing needs of its customers. These            financial instruments include commitments to extend credit and letters of credit. Those            instruments involve, to varying degrees, elements of credit and interest rate risk in            excess of the amount recognized in the balance sheets.

 

The Bank’s exposure to credit loss in the event of nonperformance            by the other party to the financial instrument for commitments to extend credit and            letters of credit is represented by

 

9

 

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the            contractual amount of those instruments. The Bank uses the same credit policies in            making commitments and conditional obligations as it does for on-balance sheet            instruments.

 

A            summary of the Bank’s financial instrument commitments is as follows:

 

 

| (in thousands)                             |   | **September 30,** |   |
|--------------------------------------------|--------|-------------------|--------|
|                                       |   | **2007**          |   | **2006** |   |
|                                       |   |              |   |   |   |   |   |
| Commitments to grant loans                 |   | $                 | 15,687 |   | $ | 15,993 |   |
| Unfunded commitments under lines of credit |   |              | 31,911 |   |   | 34,507 |   |
| Standby letters of credit                  |   |              | 2,751  |   |   | 7,290 |   |
|                                       |   |              |   |   |   |   |   |
|                                       |   | $                 | 50,349 |   | $ | 57,790 |   |

 

Commitments to extend credit are agreements to lend to a customer as            long as there is no violation of any condition established in the contract. Commitments            generally have fixed expiration dates or other termination clauses and may require            payment of a fee. Since some of the commitments are expected to expire without being            drawn upon, the total commitment amount does not necessarily represent future cash            requirements. The Bank evaluates each customer’s credit worthiness on a            case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank            upon extension of credit, is based on management’s credit evaluation of the            customer and generally consists of real estate.

 

The Bank does not issue any guarantees that would require liability            recognition or disclosure, other than its standby letters of credit. Standby letters of            credit written are conditional commitments issued by the Bank to guarantee the            performance of a customer to a third party. Generally, all letters of credit, when            issued have expiration dates within one year. The credit risk involved in issuing            letters of credit is essentially the same as those that are involved in extending loan            facilities to customers. The Bank, generally, holds collateral and/or personal            guarantees supporting these commitments. Management believes that the proceeds obtained            through a liquidation of collateral and the enforcement of guarantees would be            sufficient to cover the potential amount of future payment required under the            corresponding guarantees. The current amount of the liability as of September 30, 2007            for guarantees under standby letters of credit issued is not material.

 

**8.****New Accounting            Pronouncements**

 

In April 2007, the FASB directed the FASB Staff to issue FSP No. FIN            39-1, “Amendment of FASB Interpretation No. 39” (“FSP FIN            39-1”). FSP FIN 39-1 modifies FIN No. 39, “Offsetting of Amounts Related to            Certain Contracts”and permits companies to offset cash collateral receivables or            payables with net derivative positions under certain circumstances. FSP FIN 39-1 is            effective for fiscal years beginning after November 15, 2007, with early adoption            permitted. We are evaluating the effect of adopting FSP FIN 39-1 on our Consolidated            Financial Statements.

 

In May 2007, the FASB issued FASB Staff Position (“FSP”) FIN            48-1, “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN            48-1). FSP FIN 48-1 provides guidance on how to determine whether a tax position is            effectively settled for the purpose of recognizing

 

10

 

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previously unrecognized tax benefits. FSP FIN 48-1 is effective            retroactively to January 1, 2007. The implementation of this standard did not have a            material impact on our consolidated financial position or results of            operations.

 

Effective January 1, 2007, the Company adopted Financial Accounting            Standards Board (FASB) Statement No. 156, “Accounting for Servicing of Financial            Assets – An Amendment of FASB Statement No. 140” (SFAS “156”).            SFAS 156 requires that all separately recognized servicing assets and servicing            liabilities be initially measured at fair value, if practicable. The statement permits,            but does not require, the subsequent measurement of servicing assets and servicing            liabilities at fair value. The adoption of SFAS 156 did not have a significant effect            on the consolidated financial statements.

 

Effective January 1, 2007, the Company adopted the provisions of            Financial Accounting Standards Board (FASB) Interpretation No. 48,*“*Accounting for Uncertainty in Income            Taxes*”.*The Interpretation            provides clarification on accounting for uncertainty in income taxes recognized in an            enterprises’s financial statements in accordance with FASB Statement of Financial            Accounting Standard (SFAS) No. 109,*“*Accounting for Income            Taxes*”.*The Interpretation            prescribes a recognition threshold and measurement attribute for the financial            statement recognition and measurement of a tax position taken or expected to be taken            in a tax return, and also provides guidance on derecognition, classification, interest            and penalties, accounting in interim periods, disclosure and transition. As a result of            the Company’s evaluation of the implementation of FIN 48, no significant income            tax uncertainties were identified. Therefore, the Company recognized no adjustment for            unrecognized income tax benefits during the nine months ended September 30, 2007. Our            policy is to recognize interest and penalties on unrecognized tax benefits in            “Federal income taxes” in the Consolidated Statements of Income. The amount            of interest and penalties for the three months ended September 30, 2007 was immaterial.            The tax years subject to examination by the taxing authorities are the years ending            December 31, 2006, 2005, 2004 and 2003.

 

In March 2007, the FASB ratified EITF Issue No. 06-11, “Accounting            for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF 06-11            requires companies to recognize the income tax benefit realized from dividends or            dividend equivalents that are charged to retained earnings and paid to employees for            nonvested equity-classified employee share-based payment awards as an increase to            additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after            September 15, 2007. The Company does not expect EITF 06-11 will have a material impact            on its consolidated financial position, results of operations or cash flows.

 

In March 2007, the FASB ratified Emerging Issues Task Force Issue No.            06-10 “Accounting for Collateral Assignment Split-Dollar Life Insurance            Agreements” (EITF 06-10). EITF 06-10 provides guidance for determining a            liability for the postretirement benefit obligation as well as recognition and            measurement of the associated asset on the basis of the terms of the collateral            assignment agreement. EITF 06-10 is effective for fiscal years beginning after December            15, 2007. The Company is currently assessing the impact of EITF 06-10 on its            consolidated financial position and results of operations.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value            Option for Financial Assets and Financial Liabilities-Including an amendment of FASB            Statement No. 115”. SFAS

 

11

 

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No. 159            permits entities to choose to measure many financial instruments and certain other            items at fair value. Unrealized gains and losses on items for which the fair value            option has been elected will be recognized in earnings at each subsequent reporting            date. SFAS No. 159 is effective for our Company January 1, 2008. The Company is            evaluating the impact that the adoption of SFAS No. 159 will have on our consolidated            financial statements.

 

On September 7, 2006, the Task Force reached a conclusion on EITF Issue            No. 06-5, “Accounting for Purchases of Life Insurance – Determining the            Amount that Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4,            Accounting for Purchases of Life Insurance” (“EITF 06-5”). The Scope            of EITF 06-5 consists of six separate issues relating to accounting for life insurance            policies purchased by entities protecting against the loss of “key            persons.” The six issues are clarifications of previously issued guidance on FASB            Technical Bulletin No. 85-4. EITF 06-5 is effective for fiscal years beginning after            December 15, 2006. The adoption of EITC 06-5 did not have a material impact on the            Company’s consolidated financial statements.

 

In September 2006, the FASB’s Emerging Issues Task Force (EITF)            issued EITF Issue No. 06-4, “Accounting for Deferred Compensation and            Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance            Arrangements” (“EITF 06-4). EITF 06-4 requires the recognition of a            liability related to the postretirement benefits covered by an endorsement split-dollar            life insurance arrangement. The consensus highlights that the employer (who is also the            policyholder) has a liability for the benefit it is providing to its employee. As such,            if the policyholder has agreed to maintain the insurance policy in force for the            employee’s benefit during his or her retirement, then the liability recognized            during the employee’s active service period should be based on the future cost of            insurance to be incurred during the employee’s retirement. Alternatively if the            policy holder has agreed to provide the employee with a death benefit, then the            liability for the future death benefit should be recognized by following the guidance            in SFAS No. 106 or Accounting Principles Board (APB) Opinion No. 12, as appropriate.            For transition, an entity can choose to apply the guidance using either of the            following approaches: (a) a change in accounting principle through retrospective            application to all periods presented or (b) a change in accounting principle through a            cumulative-effect adjustment to the balance in retained earnings at the beginning of            the year of adoption. The EITF is effective for fiscal years beginning after December            15, 2007, with early adoption permitted. The Company is evaluating the potential impact            of this guidance on the Company’s consolidated financial statements.

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value            Measurements, which defines fair value, establishes a framework for measuring fair            value under GAAP, and expands disclosures about fair value measurements. FASB Statement            157 applies to all accounting pronouncements that require or permit fair value            measurements. The new guidance is effective for financial statements issued for fiscal            years beginning after November 15, 2007, and for interim periods within those fiscal            years. We are currently evaluating the potential impact, if any, of the adoption of            FASB Statement No. 157 on our consolidated financial position, results of operations            and cash flows.

 

                In            June 2007, the Emerging Issues Task Force (“EITF”) reached a final            consensus on EITF Issue No. 07-3, “Accounting for Nonrefundable Advance Payments            for Goods or Services to Be Used in Future Research and Development Activities”            (“EITF 07-3”). EITF 07-3 is effective for fiscal

 

12

 

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years            beginning after December 15, 2007. EITF 07-3 requires that non-refundable advance            payments for future research and development activities should be capitalized until the            goods have been delivered or related services have been performed. Adoption is on a            prospective basis and could impact the timing of expense recognitions for agreements            entered into after December 31, 2007. We do not expect the adoption of EITF 07-3 to            have a significant impact on our consolidated financial statements.

 

**Item 2. Management’s Discussion and            Analysis of Financial Condition and Results of Operations**

 

**Forward-Looking Statements**

 

The Private Securities Litigation Reform Act of 1995 contains safe            harbor provisions regarding forward-looking statements. When used in this discussion,            the words believes, anticipates, contemplates, expects, and similar expressions are            intended to identify forward-looking statements. Such statements are subject to certain            risks and uncertainties, which could cause actual results to differ materially from            those projected. Those risks and uncertainties include changes in interest rates, risks            associated with the effect of opening a new branch, the ability to control costs and            expenses, demand for real estate and general economic conditions. The Company            undertakes no obligation to publicly release the results of any revisions to those            forward-looking statements which may be made to reflect events or circumstances after            the date hereof or to reflect the occurrence of unanticipated events.

 

**Critical Accounting Policies**

 

Note 2 to the Company’s consolidated financial statements for the            year ended December 31, 2006 (incorporated by reference in Item 8 of the Form 10-K)            lists significant accounting policies used in the development and presentation of its            financial statements. This discussion and analysis, the significant accounting            policies, and other financial statement disclosures identify and address key variables            and other qualitative and quantitative factors that are necessary for an understanding            and evaluation of the Company and its results of operations.

 

Material estimates that are particularly susceptible to significant            change in the near term relate to the determination of the allowance for loan losses,            accounting for stock options, the valuation of deferred tax assets and the            determination of other-than-temporary impairment losses on securities. Please refer to            the discussion of the allowance for loan losses calculation under “Non-performing            Assets and Allowance for Loan Losses” in the “Financial Condition”            section.

 

The Company adopted SFAS No. 123(R) “Share-Based Payment” as            of January 1, 2006, which requires that transactions be recognized as compensation cost            in the income statement based on their fair values on the measurement date, which, for            the Company is the grant date. The Norwood Financial Corp 2006 Stock Option Plan was            approved on April 25, 2006 and the Company granted 47,700 options during 2006. For the            three and nine months ended September 30, 2007, salaries and employee benefit expense            includes $48,000 and $199,000 related to the adoption of Statement No. 123(R) and            $51,000 and $85,000 for the three and nine months ended September 30, 2006.

 

13

 

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The deferred income taxes reflect temporary differences in the            recognition of the revenue and expenses for tax reporting and financial statement            purposes, principally because certain items are recognized in different periods for            financial reporting and tax return purposes. Although realization is not assured, the            Company believes that it is more likely than not that all deferred tax assets will be            realized.

 

In estimating other-than-temporary impairment losses on securities, the            Company considers 1) the length of time and extent to which the fair value has been            less than cost 2) the financial condition of the issuer and 3) the intent and ability            of the Company to hold the security to allow for a recovery to fair value. The Company            believes that the unrealized losses at September 30, 2007 and December 31, 2006            represent temporary impairment of the securities, related to changes in interest            rates.

 

**Changes in Financial Condition**

 

**General**

 

Total assets as of September 30, 2007 were $472.9 million compared to            $454.4 million as of December 31, 2006, an increase of $18.5 million, or 4.1%. The            increase reflects a $13.0 million increase in loans receivable and a $5.8 million            increase in securities available for sale, funded by a $9.5 million increase in            deposits and a $10 million increase in other borrowings.

 

**Securities**

 

The fair value of securities available for sale as of September 30, 2007            was $118.7 million compared to $112.9 million as of December 31, 2006. The Company            purchased $43.0 million of securities principally using the proceeds from $38.0 million            of securities called, maturities and principal reductions.

 

The carrying value of the Company’s securities portfolio            (Available-For-Sale and Held-to-Maturity) consisted of the following:

 

|                              |   | **September 30, 2007** |    | **December 31, 2006** |
|-----------------------------------|--------|------------------------|---------|-----------------------|
| (dollars in thousands)            |   | **Amount**             |    | **% of portfolio**    |   | **Amount** |   | **% of portfolio** |
|                              |   |                   |    |                  |   |   |   |   |   |   |   |   |
| US Government agencies            |   | $                      | 43,555  |                  | 36.5 | % |   | $ | 47,581 |   | 41.8 | % |
| States and political subdivisions |   |                   | 21,766  |                  | 18.2 |   |   |   | 17,419 |   | 15.3 |   |
| Corporate securities              |   |                   | 2,978   |                  | 2.5 |   |   |   | 8,439 |   | 7.4 |   |
| Mortgage-backed securities        |   |                   | 49,591  |                  | 41.5 |   |   |   | 38,652 |   | 33.9 |   |
| Equity securities                 |   |                   | 1,551   |                  | 1.3 |   |   |   | 1,775 |   | 1.6 |   |
| Total                             |   | $                      | 119,441 |                  | 100.0 | % |   | $ | 113,866 |   | 100.0 | % |

 

The Company has securities in an unrealized loss position. In            Management’s opinion, the unrealized losses reflect changes in interest rates            subsequent to the acquisition of specific securities. The Company’s            available-for-sale portfolio has an average repricing term of 2.9 years. Interest rates            in the two to four year section of the treasury yield curve decreased during the nine            months ended September 30, 2007, favorably impacting the fair value of individual            securities. Management believes that the unrealized losses represent temporary            impairment of the securities

 

14

 

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and are            the result of changes in interest rates. The Company has the intent and ability to hold            these investments until maturity or market price recovery.

 

**Loans Receivable**

 

Loans receivable totaled $328.6 million compared to $315.6 million as of            December 31, 2006. Commercial real estate loans increased $6.3 million reflecting            continued commercial growth in the Company’s market area. Commercial, financial            and agricultural decreased $3.5 million principally due to seasonal pay downs in            various lines of credit. The growth in residential real estate loans of $13.3 million            has principally been in fixed rate first lien residential mortgages and home equity            loans. The Company does not originate any non-traditional mortgage products such as            interest-only loans or option adjustable-rate mortgages, does not participate in the            sub-prime mortgage lending market, nor offer any terms over 30 years.

 

Set forth below is selected data relating to the composition of the loan            portfolio at the dates indicated:

 

| Types of loans                         | **September 30, 2007** |    | **December 31, 2006** |
|----------------------------------------|------------------------|---------|-----------------------|
| (dollars in thousands)                 |                   |    |                  |   |   |   |   |   |   |   |   |   |   |
|                                   |                   |    |                  |   |   |   |   |   |   |   |   |   |   |
| Real Estate-Residential                | $                      | 127,131 |                  |   | 38.7 | % |   | $ | 113,783 |   |   | 36.0 | % |
| Commercial                             |                   | 133,970 |                  |   | 40.7 |   |   |   | 127,640 |   |   | 40.4 |   |
| Construction                           |                   | 18,126  |                  |   | 5.5 |   |   |   | 18,955 |   |   | 6.0 |   |
| Commercial, financial and agricultural |                   | 30,540  |                  |   | 9.3 |   |   |   | 34,019 |   |   | 10.8 |   |
| Consumer loans to individuals          |                   | 19,087  |                  |   | 5.8 |   |   |   | 21,520 |   |   | 6.8 |   |
| Total loans                            |                   | 328,854 |                  |   | 100.0 | % |   |   | 315,917 |   |   | 100.0 | % |
|                                   |                   |    |                  |   |   |   |   |   |   |   |   |   |   |
| Deferred fees (net)                    |                   | (272    | )                     |   |   |   |   |   | (350 | ) |   |   |   |
|                                   |                   | 328,582 |                  |   |   |   |   |   | 315,567 |   |   |   |   |
| Allowance for loan losses              |                   | (3,979  | )                     |   |   |   |   |   | (3,828 | ) |   |   |   |
| Net loans receivable                   | $                      | 324,603 |                  |   |   |   |   | $ | 311,739 |   |   |   |   |
|                                   |                   |    |                  |   |   |   |   |   |   |   |   |   |   |

 

 

15

 

----

**Allowance for Loan Losses and Non-performing            Assets**

 

Following is a summary of changes in the allowance for loan losses for            the periods indicated:

 

|                                         | **Three Months Ended** |   |     | **Nine Months Ended** |
|----------------------------------------------|------------------------|--------|----------|-----------------------|
|                                         | **September 30,**      |   |     | **September 30,**     |
| (dollars in thousands)                       | **2007**               |   | **2006** |                  |   | **2007** |   | **2006** |
|                                         |                   |   |     |                  |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance, beginning                           | $                      | 3,900  |     |                  | $ | 3,794 |   |   |   | $ | 3,828 |   |   | $ | 3,669 |   |
| Provision for loan losses                    |                   | 90     |     |                  |   | 45 |   |   |   |   | 195 |   |   |   | 170 |   |
| Charge-offs                                  |                   | (16    | )        |                  |   | (34 | ) |   |   |   | (83 | ) |   |   | (84 | ) |
| Recoveries                                   |                   | 5      |     |                  |   | 23 |   |   |   |   | 39 |   |   |   | 73 |   |
| Net charge-offs                              |                   | (11    | )        |                  |   | (11 | ) |   |   |   | (44 | ) |   |   | (11) |   |
| Balance, ending                              | $                      | 3,979  |     |                  | $ | 3,828 |   |   |   | $ | 3,979 |   |   | $ | 3,828 |   |
|                                         |                   |   |     |                  |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance to total loans                     |                   | 1.21   | %        |                  |   | 1.22 | % |   |   |   | 1.21 | % |   |   | 1.22 | % |
| Net charge-offs to average loans(annualized) |                   | .01    | %        |                  |   | .01 | % |   |   |   | .02 | % |   |   | — |   |

 

 

The allowance for loan losses totaled $3,979,000 as of September 30,            2007 and represented 1.21% of total loans compared to $3,828,000 and 1.21% as of            December 31, 2006. The Company had net charge-offs of $44,000 for the nine months ended            September 30, 2007 compared to $11,000 for the similar period in 2006. The charge-offs            in 2007 were principally due to losses on repossessed automobiles. The provision for            loan losses for the nine months ended September 30, 2007 was $195,000, compared to            $170,000 for the similar period in 2006.

 

The Company assesses the adequacy of the allowance for loan losses on a            quarterly basis. The process includes an analysis of the risks inherent in the loan            portfolio. It includes an analysis of impaired loans and a historical review of credit            losses by loan type. Other factors considered include: concentration of credit in            specific industries; economic and industry conditions; trends in delinquencies and loan            risk-rated classifications; large dollar exposures and loan growth. Management            considers the allowance adequate at September 30, 2007 based on the Company’s            criteria. However, there can be no assurance that the allowance for loan losses will be            adequate to cover significant losses, if any that might be incurred in the            future.

 

16

 

----

As of September 30, 2007, non-performing loans totaled $119,000, which            is .04% of total loans compared to $409,000, or .13% of total loans at December 31,            2006. The Company resolved its largest non-performing loan in the third quarter of 2007            with full collection of principal, interest and fees. The following table sets forth            information regarding non-performing loans and foreclosed real estate at the dates            indicated:

 

|                                                                                  |   | **September 30, 2007** |    | **December 31, 2006** |
|---------------------------------------------------------------------------------------|--------|------------------------|---------|-----------------------|
| (dollars in thousands)                                                                |   |                   |    |                  |   |   |   |   |   |
| Loans accounted for on a non accrual basis:                                           |   |                   |    |                  |   |   |   |   |   |
| Commercial and all other                                                              |   | $                      | — |                  |   |   | $ | — |   |
| Real Estate                                                                           |   |                   | 114     |                  |   |   |   | 392 |   |
| Consumer                                                                              |   |                   | 2       |                  |   |   |   | 17 |   |
| Total                                                                                 |   |                   | 116     |                  |   |   |   | 409 |   |
|                                                                                  |   |                   |    |                  |   |   |   |   |   |
| Accruing loans which are contractually                                                |   |                   |    |                  |   |   |   |   |   |
| past due 90 days or more                                                              |   |                   | 3       |                  |   |   |   | — |   |
| Total non-performing loans                                                            |   |                   | 119     |                  |   |   |   | 409 |   |
| Foreclosed real estate                                                                |   |                   | — |                  |   |   |   | — |   |
| Total non-performing assets                                                           |   | $                      | 119     |                  |   |   | $ | 409 |   |
|                                                                                  |   |                   |    |                  |   |   |   |   |   |
| Allowance for loan losses                                                             |   | $                      | 3,979   |                  |   |   | $ | 3,828 |   |
|                                                                                  |   |                   |    |                  |   |   |   |   |   |
| Allowance for loan losses coverage of non-performing                            loans |   |                   | 33.4    | x                     |   |   |   | 9.4 | x |
| Non-performing loans to total loans                                                   |   |                   | .04     | %                     |   |   |   | .13 | % |
| Non-performing assets to total assets                                                 |   |                   | .03     | %                     |   |   |   | .09 | % |

 

**Deposits** 

 

Total deposits as of September 30, 2007 were $367.6 million increasing            from $358.1 million as of December 31, 2006. The increase of $9.5 million was used to            fund loan growth. The increase in non-interest bearing demand deposits of $7.0 million            and money market accounts of $4.7 million is due in part to new commercial accounts and            seasonality of certain corporate and municipal accounts.

 

17

 

----

The following table sets forth deposit balances as of the dates            indicated.

 

| (dollars in thousands)      | **September 30, 2007** |    | **December 31, 2006** |   |
|-----------------------------|------------------------|---------|-----------------------|--------|
|                        |                   |    |                  |   |   |   |
| Non-interest bearing demand | $                      | 60,880  |                  | $      | 53,856 |   |
| Interest bearing demand     |                   | 38,367  |                  |   | 36,600 |   |
| Money Market                |                   | 54,779  |                  |   | 50,048 |   |
| Savings                     |                   | 44,451  |                  |   | 45,144 |   |
| Time deposits <$100,000  |                   | 115,000 |                  |   | 115,719 |   |
| Time deposits >$100,000  |                   | 54,076  |                  |   | 56,736 |   |
|                        |                   |    |                  |   |   |   |
| Total                       | $                      | 367,553 |                  | $      | 358,103 |   |
|                        |                   |    |                  |   |   |   |

 

**Short-term Borrowings**

 

Short-term borrowings as of September 30, 2007 totaled $22.6 million            compared to $22.7 million as of December 31, 2006.

 

Short-term borrowings consist of the following:

 

 

| (dollars in thousands)                                                    |   | **September 30, 2007** |   |   | **December 31, 2006** |   |
|---------------------------------------------------------------------------|--------|------------------------|--------|--------|-----------------------|--------|
|                                                                      |   |                   |   |   |                  |   |   |   |
| Securities sold under agreements to                            repurchase |   | $                      | 18,879 |   |                  | $      | 21,736 |   |
| Federal Funds Purchased                                                   |   |                   | 2,750  |   |                  |   | - |   |
| U.S. Treasury demand notes                                                |   |                   | 999    |   |                  |   | 1,000 |   |
|                                                                      |   | $                      | 22,628 |   |                  | $      | 22,736 |   |

 

 

**Other Borrowings**

 

Other            borrowings consist of notes from the Federal Home Loan Bank of Pittsburgh as detailed            in the following: (dollars in thousands)

 

|                                       |   | **September 30, 2007** |   | **December 31, 2006** |   |
|--------------------------------------------|--------|------------------------|--------|-----------------------|--------|
| Fixed rate note due April 2008 at 4.17%    |   | $                      | 5,000  |                  | $      | 5,000 |   |
| Convertible note due April 2009 at 5.53%   |   |                   | 5,000  |                  |   | 5,000 |   |
| Convertible note due January 2011 at 5.24% |   |                   | 3,000  |                  |   | 3,000 |   |
| Convertible note due January 2017 at 4.71% |   |                   | 10,000 |                  |   | — |   |
|                                       |   | $                      | 23,000 |                  | $      | 13,000 |   |

 

 

18

 

----

The convertible notes contain an option that allows the FHLB, at            quarterly intervals to change the note to an adjustable-rate advance at three-month            LIBOR plus 11 to 16 basis points. If the notes are converted, the option allows the            Bank to put the funds back to the FHLB without penalty.

 

**Off-Balance Sheet Arrangements**

 

The Bank is a party to financial instruments with off-balance sheet risk            in the normal course of business to meet the financing needs of its customers. These            financial instruments include commitments to extend credit and letters of credit. Those            instruments involve, to varying degrees, elements of credit and interest rate risk in            excess of the amount recognized in the balance sheet.

 

The Bank’s exposure to credit loss in the event of nonperformance            by the other party to the financial instrument for commitments to extend credit and            letters of credit is represented by the contractual amount of those instruments. The            Bank uses the same credit policies in making commitments and conditional obligations as            it does for on-balance sheet instruments.

 

A summary of the contractual amount of the Company’s financial            instrument commitments is as follows:

 

 

|                                       |   | **September 30,****2007** |   | **December** **31,**    **2006** |   |
|--------------------------------------------|--------|---------------------------|--------|-----------------------------------------------------------|--------|
|                                       |   | **(in thousands)**        |   |
| Commitments to grant loans                 |   | $                         | 15,687 |                                                      | $      | 12,611 |   |
| Unfunded commitments under lines of credit |   |                      | 31,911 |                                                      |   | 34,152 |   |
| Standby letters of credit                  |   |                      | 2,751  |                                                      |   | 7,215 |   |
|                                       |   |                      |   |                                                      |   |   |   |
|                                       |   | $                         | 50,349 |                                                      | $      | 53,978 |   |

 

 

**Stockholders’ Equity and Capital Ratios**

 

At September 30, 2007, total stockholders’ equity totaled $54.7            million, compared to $52.2 million as of December 31, 2006. The net change in            stockholders’ equity was primarily due to $4,839,000 in net income, that was            partially offset by $1,918,000 of cash dividends declared and $1,385,000 in treasury            stock purchased. In addition, accumulated other comprehensive income increased $468,000            due to an increase in fair value of securities in the available for sale portfolio.            This increase in fair value is the result of a change in interest rates, which may            impact the fair value of the securities. Because of interest rate volatility, the            Company’s accumulated other comprehensive income could materially fluctuate for            each interim and year-end period.  

 

19

 

----

A comparison of the Company’s regulatory capital ratios is as            follows:

 

|                                                 |   | **September 30, 2007** |   | **December 31,**

**2006** |   |
|------------------------------------------------------|--------|------------------------|--------|----------------------------|--------|
| Tier 1 Capital                                       |   |                   |   |                       |   |
| (To average assets)                                  |   | 11.55                  | %      | 11.43                      | %      |
| Tier 1 Capital                                       |   |                   |   |                       |   |
| (To risk-weighted assets)                            |   | 16.27                  | %      | 15.67                      | %      |
| Total Capital                                        |   |                   |   |                       |   |
| (To risk-weighted                            assets) |   | 17.60                  | %      | 16.99                      | %      |

 

The minimum capital requirements imposed by the FDIC on the Bank for            leverage, Tier 1 and Total Capital are 4%, 4% and 8%, respectively. The Company has            similar capital requirements imposed by the Board of Governors of the Federal Reserve            System (FRB). The Bank is also subject to more stringent Pennsylvania Department of            Banking (PDB) guidelines. The Bank’s capital ratios do not differ significantly            from the Company’s ratios. Although not adopted in regulation form, the PDB            utilizes capital standards requiring a minimum of 6.5% leverage capital and 10% total            capital. The Company and the Bank were in compliance with the FRB, FDIC and PDB capital            requirements as of September 30, 2007 and December 31, 2006.

 

**Liquidity**

 

As of September 30, 2007, the Company had cash and cash equivalents of            $8.9 million in the form of cash, due from banks, and short-term deposits with other            institutions. In addition, the Company had total securities available for sale of            $118.7 million which could be used for liquidity needs. This totals $127.6 million and            represents 27.0% of total assets compared to $122.4 million and 26.9% of total assets            as of December 31, 2006. The Company also monitors other liquidity measures, all of            which were within the Company’s policy guidelines as of September 30, 2007 and            December 31, 2006. Based upon these measures, the Company believes its liquidity is            adequate.

 

**Capital Resources**

 

The Company has a line of credit commitment available from the Federal            Home Loan Bank (FHLB) of Pittsburgh for borrowings of up to $20,000,000 which expires            in December 2011. There were no borrowings under this line at September 30, 2007 and            December 31, 2006. The Company has a line of credit commitment available from PNC Bank            for $12,000,000, of which $2,750,000 and -0- was outstanding as of September 30, 2007            and December 31, 2006, respectively. The Company also has line of credit commitments            available from Atlantic Central Bankers Bank for $7,000,000 and Wachovia Bank for            $2,000,000. There were no borrowings under these lines at September 30, 2007 and            December 31, 2006.

 

The Bank’s maximum borrowing capacity with the FHLB totals            approximately $233 million of which $23 million was outstanding at September 30, 2007            and $13 million was outstanding at December 31, 2006. Advances from the FHLB are            secured by qualifying assets of the            Bank.          

 

20

 

----

**Results of Operations**

NORWOOD            FINANCIAL CORP.

Consolidated Average Balance Sheets with Resultant Interest and            Rates

(Tax            Equivalent Basis, dollars in thousands)

 

|                                                                        |   | **Three Months Ended September 30,** |    |
|-----------------------------------------------------------------------------|--------|--------------------------------------|---------|
|                                                                        |   | **2007**                             |    | **2006** |   |
|                                                                        |   | **Average Balance****(2)**           |    | **Interest****(1)** |   | **Average****Rate****(3)** |   | **Average****Balance****(2)** |   | **Interest****(1)** |   | **Average****Rate****(3)** |   |
| Assets                                                                      |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                                    |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                          |   | $                                    | 1,907   |   | $ | 26 |   | 5.45 | % | $ | 2,801 |   | $ | 35 |   | 5.00 | % |
| Interest bearing deposits with banks                                        |   |                                 | 581     |   |   | 7 |   | 4.82 |   |   | 71 |   |   | 1 |   | 5.63 |   |
| Securities held-to-maturity(1)                                              |   |                                 | 708     |   |   | 17 |   | 9.60 |   |   | 954 |   |   | 22 |   | 9.22 |   |
| Securities available for sale:                                              |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                     |   |                                 | 98,780  |   |   | 1,181 |   | 4.78 |   |   | 100,510 |   |   | 945 |   | 3.76 |   |
| Tax-exempt                                                                  |   |                                 | 19,761  |   |   | 239 |   | 4.84 |   |   | 16,520 |   |   | 221 |   | 5.35 |   |
| Total securities available for sale (1)                                     |   |                                 | 118,541 |   |   | 1,420 |   | 4.79 |   |   | 117,030 |   |   | 1,166 |   | 3.99 |   |
| Loans receivable (4)(5)                                                     |   |                                 | 325,352 |   |   | 6,092 |   | 7.49 |   |   | 305,081 |   |   | 5,554 |   | 7.28 |   |
| Total interest earning assets                                               |   |                                 | 447,089 |   |   | 7,562 |   | 6.77 |   |   | 425,937 |   |   | 6,778 |   | 6.37 |   |
| Non-interest earning assets:                                                |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                     |   |                                 | 7,753   |   |   |   |   |   |   |   | 9,219 |   |   |   |   |   |   |
| Allowance for loan losses                                                   |   |                                 | (3,938  | ) |   |   |   |   |   |   | (3,820 | ) |   |   |   |   |   |
| Other assets                                                                |   |                                 | 17,606  |   |   |   |   |   |   |   | 16,967 |   |   |   |   |   |   |
| Total non-interest earning assets                                           |   |                                 | 21,421  |   |   |   |   |   |   |   | 22,366 |   |   |   |   |   |   |
| Total Assets                                                                |   | $                                    | 468,510 |   |   |   |   |   |   | $ | 448,303 |   |   |   |   |   |   |
| Liabilities and Stockholders’ Equity                                  |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                                               |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing demand and money market                                    |   | $                                    | 93,153  |   |   | 489 |   | 2.10 |   | $ | 99,693 |   |   | 461 |   | 1.85 |   |
| Savings                                                                     |   |                                 | 47,612  |   |   | 56 |   | 0.47 |   |   | 49,330 |   |   | 58 |   | 0.47 |   |
| Time                                                                        |   |                                 | 169,363 |   |   | 1,944 |   | 4.59 |   |   | 145,595 |   |   | 1,513 |   | 4.16 |   |
| Total interest bearing deposits                                             |   |                                 | 310,128 |   |   | 2,489 |   | 3.21 |   |   | 294,618 |   |   | 2,032 |   | 2.76 |   |
| Short-term borrowings                                                       |   |                                 | 18,477  |   |   | 195 |   | 4.22 |   |   | 20,646 |   |   | 235 |   | 4.55 |   |
| Other borrowings                                                            |   |                                 | 23,000  |   |   | 281 |   | 4.89 |   |   | 20,793 |   |   | 278 |   | 5.35 |   |
| Total interest bearing liabilities                                          |   |                                 | 351,605 |   |   | 2,965 |   | 3.37 |   |   | 336,057 |   |   | 2,545 |   | 3.03 |   |
| Non-interest bearing liabilities:                                           |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                             |   |                                 | 58,531  |   |   |   |   |   |   |   | 58,392 |   |   |   |   |   |   |
| Other liabilities                                                           |   |                                 | 4,472   |   |   |   |   |   |   |   | 3,792 |   |   |   |   |   |   |
| Total non-interest bearing liabilities                                      |   |                                 | 63,003  |   |   |   |   |   |   |   | 62,184 |   |   |   |   |   |   |
| Stockholders’ equity                                                  |   |                                 | 53,902  |   |   |   |   |   |   |   | 50,062 |   |   |   |   |   |   |
| Total Liabilities and Stockholders’                            Equity |   | $                                    | 468,510 |   |   |   |   |   |   | $ | 448,303 |   |   |   |   |   |   |
|                                                                        |   |                                 |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (tax equivalent basis)                                  |   |                                 |    |   |   | 4,597 |   | 3.39 | % |   |   |   |   | 4,233 |   | 3.34 | % |
| Tax-equivalent basis adjustment                                             |   |                                 |    |   |   | (105 | ) |   |   |   |   |   |   | (131 | ) |   |   |
| Net interest income                                                         |   |                                 |    |   | $ | 4,492 |   |   |   |   |   |   | $ | 4,102 |   |   |   |
| Net interest margin (tax equivalent basis)                                  |   |                                 |    |   |   |   |   | 4.11 | % |   |   |   |   |   |   | 3.98 | % |

 

| (1)

(2) | Interest and yields are presented on a                            tax-equivalent basis using a marginal tax rate of                            34%.

Average balances have been calculated based on daily                            balances. |
|----------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| (3) | Annualized |
|-----|------------|

| (4) | Loan balances include non-accrual loans and are net of                            unearned income. |
|-----|----------------------------------------------------------------------------------------------------|

| (5) | Loan yields include the effect of amortization of                            deferred fees, net of costs. |
|-----|-----------------------------------------------------------------------------------------------------------|

 

21

 

----

**Rate/Volume Analysis.**The following table            shows the fully taxable equivalent effect of changes in volumes and rates on interest            income and interest expense. Changes in net interest income that could not be            specifically identified as either a rate or volume change were allocated            proportionately to changes in volume and changes in rate.

 

 

| **Increase/(Decrease)****Three Months Ended September 30, 2007 Compared                            to****Three Months Ended September 30, 2006****Variance due to** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                |   | **Volume** |   | **Rate** |   | **Net** |   |
|                                                                                                                                                                |   | **(dollars in thousands)** |   |
| Interest earning assets:                                                                                                                                            |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                                                                                                                  |   | $ | (27 | ) | $ | 18 |   | $ | (9 | ) |
| Interest bearing deposits with banks                                                                                                                                |   |   | 7 |   |   | (1 | ) |   | 6 |   |
| Securities held to maturity                                                                                                                                         |   |   | (11 | ) |   | 6 |   |   | (5 | ) |
| Securities available for sale:                                                                                                                                      |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                                                                                             |   |   | (108 | ) |   | 344 |   |   | 236 |   |
| Tax-exempt securities                                                                                                                                               |   |   | 126 |   |   | (108 | ) |   | 18 |   |
| Total securities                                                                                                                                                    |   |   | 18 |   |   | 236 |   |   | 254 |   |
| Loans receivable                                                                                                                                                    |   |   | 376 |   |   | 162 |   |   | 538 |   |
| Total interest earning assets                                                                                                                                       |   |   | 363 |   |   | 421 |   |   | 784 |   |
|                                                                                                                                                                |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                                                                                                                                       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing demand and money market                                                                                                                            |   |   | (154 | ) |   | 182 |   |   | 28 |   |
| Savings                                                                                                                                                             |   |   | (2 | ) |   | - |   |   | (2 | ) |
| Time                                                                                                                                                                |   |   | 263 |   |   | 168 |   |   | 431 |   |
| Total interest bearing deposits                                                                                                                                     |   |   | 107 |   |   | 350 |   |   | 457 |   |
| Short-term borrowings                                                                                                                                               |   |   | (24 | ) |   | (16 | ) |   | (40 | ) |
| Other borrowings                                                                                                                                                    |   |   | 107 |   |   | (104 | ) |   | 3 |   |
| Total interest bearing liabilities                                                                                                                                  |   |   | 190 |   |   | 230 |   |   | 420 |   |
| Net interest income (tax-equivalent basis)                                                                                                                          |   | $ | 173 |   | $ | 191 |   | $ | 364 |   |
|                                                                                                                                                                |   |   |   |   |   |   |   |   |   |   |

 

**Comparison of Operating Results for Three Months Ended September            30, 2007 and September 30, 2006**

 

**General**

 

For the three months ended September 30, 2007, net income totaled            $1,806,000, an increase of $284,000, or 18.7% over the $1,522,000 earned in the similar            period of 2006. Earnings per share for the current period were $.65 basic and $.64 on a            diluted basis compared to $.54 basic and $.53 on a diluted basis for the three months            ended September 30, 2006. The resulting annualized return on average assets and return            on average equity for the three months ended September 30, 2007 were 1.53% and 13.29%,            respectively, compared to 1.35% and 12.06% respectively, for the similar period in            2006.

 

22

 

----

> 
The                following table sets forth changes in net income:

 

| (dollars in thousands)                                                          |   | **Three Months Ended****September 30, 2007 to**

**September 30, 2006** |   |
|---------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------|--------|
|                                                                            |   |                                                                    |   |   |
| Net income three months ended September 30,                            2006     |   | $                                                                       | 1,522  |   |
|                                                                            |   |                                                                    |   |   |
| Change due to:                                                                  |   |                                                                    |   |   |
| Net interest income                                                             |   |                                                                    | 390    |   |
| Provision for loan losses                                                       |   |                                                                    | (45)   |   |
| Net realized gains on sales of securities                                       |   |                                                                    | (45)   |   |
| Gains on sale of mortgage loans and servicing                            rights |   |                                                                    | 5      |   |
| All other income                                                                |   |                                                                    | 59     |   |
| Salaries and employee benefits                                                  |   |                                                                    | 50     |   |
| All other expenses                                                              |   |                                                                    | (107   | ) |
| Income tax effect                                                               |   |                                                                    | (23    | ) |
|                                                                            |   |                                                                    |   |   |
| Net income three months ended September 30,                            2007     |   | $                                                                       | 1,806  |   |
|                                                                            |   |                                                                    |   |   |

 

**Net Interest Income**

 

Net interest income on a fully taxable equivalent basis (fte) for the            three months ended September 30, 2007 totaled $4,597,000, an increase of $364,000, or            8.6%, over the similar period in 2006. The fte net interest spread and net interest            margin were 3.39% and 4.11%, respectively, compared to 3.34% and 3.98%, respectively            for the three months ended September 30, 2006. The increase in the net interest margin            was principally due to an increase in the yield on the securities available for sale            portfolio, 80 basis points; a $20.3 million increase in the loan portfolio with a 21            basis point increase in its yield and the collection of $54,000 of delinquent interest.            This offset the 45 basis point increase in the cost of deposits, due in part to a $23.8            million increase in time deposits.

 

Interest income totaled $7,562,000 with an fte yield of 6.77% for the            three months ended September 30, 2007 increasing from $6,778,000 and 6.37% for the            similar period in 2006. Average loans increased $20.3 million and represented 72.8% of            average earning assets compared to 71.6% for the 2006 period. The average yield on the            loan portfolio also increased to 7.49% in the current period compared to 7.28% for the            similar period in 2006. A portion of the increase, 7 basis points, was attributable to            the collection of delinquent interest. The prime rate of interest decreased 50 basis            points on September 18, 2007 to 7.75%. Going forward, this decrease will impact the            Bank’s floating rate loan portfolio, which totaled $76.2 million as of September            30, 2007. The yield on securities available for sale portfolio increased 80 basis            points to 4.79% in the current period. The increase is due to lower yielding securities            maturing with the proceeds reinvested at higher yields.

 

23

 

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Interest expense for the three months ended September 30, 2007 totaled            $2,965,000 at an average cost of 3.37% increasing from $2,545,000 and 3.03% for the            similar period in 2006. The increase was principally related to a $23.8 million            increase in time deposits accompanied by a 43 basis point increase in cost of time            deposits to 4.59%. The increase in cost was due to lower yielding time deposits            maturing then repricing at higher costs. Deposits have continued to shift to higher            costing instruments with average time deposits representing 48.2% of interest-bearing            liabilities in 2007 compared to 43.3% in 2006.

 

**Other Income**

 

Other income for the three months ended September 30, 2007 totaled            $913,000 compared to $894,000 for the similar period in 2006. The increase was            principally due to an increase of $28,000 of income from fiduciary activities related            to higher estate fees and growth in assets under management. Service charges and fees            increased $19,000 reflecting higher levels of debit card activity, and letter of credit            fees. There were no realized gains on the sales of securities for the 2007 period            compared to $45,000 for the similar period in 2006.

 

**Other Expenses**

 

Other expenses for the three months ended September 30, 2007 totaled            $2,787,000, an increase of $57,000 compared to $2,730,000 for the similar period of            2006. Salaries and employee benefit costs decreased $50,000 due to lower ESOP expense            of $148,000, offset by an increase of $40,000 in 401k expense and $34,000 related to            incentives. Occupancy and equipment expense increased $71,000 reflecting costs related            to the new Tannersville office. In the 2007 period the Company made $75,000 in            charitable contributions (included in Other) which qualified for $67,500 in            Pennsylvania Educational Improvement Tax Credit (included in Taxes, other than            income).

 

**Income Tax Expense**

 

Income tax expense totaled $722,000 for the three months ended September            30, 2007 for an effective tax rate of 28.6% compared to $699,000 and an effective tax            rate of 31.5% for the similar period in 2006. The decrease in effective tax rate was            due to a higher level of tax-exempt income.

 

24

 

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**Results of Operations**

NORWOOD            FINANCIAL CORP.

Consolidated Average Balance Sheets with Resultant Interest and            Rates

(Tax            Equivalent Basis, dollars in thousands)

 

|                                                                        |   | **Nine Months Ended September 30,** |    |
|-----------------------------------------------------------------------------|--------|-------------------------------------|---------|
|                                                                        |   | **2007**                            |    | **2006** |   |
|                                                                        |   | **Average Balance****(2)**          |    | **Interest****(1)** |   | **Average****Rate****(3)** |   | **Average****Balance****(2)** |   | **Interest****(1)** |   | **Average****Rate****(3)** |   |
| Assets                                                                      |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                                    |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                          |   | $                                   | 3,118   |   | $ | 123 |   | 5.26 | % | $ | 3,100 |   | $ | 118 |   | 5.08 | % |
| Interest bearing deposits with banks                                        |   |                                | 549     |   |   | 21 |   | 5.10 |   |   | 106 |   |   | 3 |   | 3.77 |   |
| Securities held-to-maturity(1)                                              |   |                                | 871     |   |   | 59 |   | 9.03 |   |   | 989 |   |   | 68 |   | 9.17 |   |
| Securities available for sale:                                              |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                     |   |                                | 98,076  |   |   | 3,321 |   | 4.51 |   |   | 99,573 |   |   | 2,704 |   | 3.62 |   |
| Tax-exempt                                                                  |   |                                | 18,814  |   |   | 767 |   | 5.44 |   |   | 17,526 |   |   | 715 |   | 5.44 |   |
| Total securities available for sale (1)                                     |   |                                | 116,890 |   |   | 4,088 |   | 4.66 |   |   | 117,099 |   |   | 3,419 |   | 3.89 |   |
| Loans receivable (4)(5)                                                     |   |                                | 321,812 |   |   | 17,889 |   | 7.41 |   |   | 297,175 |   |   | 15,780 |   | 7.08 |   |
| Total interest earning assets                                               |   |                                | 443,240 |   |   | 22,180 |   | 6.67 |   |   | 418,469 |   |   | 19,388 |   | 6.18 |   |
| Non-interest earning assets:                                                |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                     |   |                                | 8,098   |   |   |   |   |   |   |   | 8,713 |   |   |   |   |   |   |
| Allowance for loan losses                                                   |   |                                | (3,895  | ) |   |   |   |   |   |   | (3,769 | ) |   |   |   |   |   |
| Other assets                                                                |   |                                | 17,348  |   |   |   |   |   |   |   | 16,931 |   |   |   |   |   |   |
| Total non-interest earning assets                                           |   |                                | 21,551  |   |   |   |   |   |   |   | 21,875 |   |   |   |   |   |   |
| Total Assets                                                                |   | $                                   | 464,791 |   |   |   |   |   |   | $ | 440,344 |   |   |   |   |   |   |
| Liabilities and Stockholders’ Equity                                  |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                                               |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing demand and money market                                    |   | $                                   | 90,244  |   |   | 1,382 |   | 2.04 |   | $ | 99,308 |   |   | 1,270 |   | 1.71 |   |
| Savings                                                                     |   |                                | 46,563  |   |   | 163 |   | 0.47 |   |   | 51,198 |   |   | 178 |   | 0.46 |   |
| Time                                                                        |   |                                | 171,983 |   |   | 5,904 |   | 4.58 |   |   | 138,965 |   |   | 3,912 |   | 3.75 |   |
| Total interest bearing deposits                                             |   |                                | 308,790 |   |   | 7,449 |   | 3.22 |   |   | 289,471 |   |   | 5,360 |   | 2.47 |   |
| Short-term borrowings                                                       |   |                                | 20,211  |   |   | 656 |   | 4.33 |   |   | 18,557 |   |   | 585 |   | 4.20 |   |
| Other borrowings                                                            |   |                                | 22,084  |   |   | 808 |   | 4.88 |   |   | 25,465 |   |   | 991 |   | 5.19 |   |
| Total interest bearing liabilities                                          |   |                                | 351,085 |   |   | 8,913 |   | 3.38 |   |   | 333,493 |   |   | 6,936 |   | 2.77 |   |
| Non-interest bearing liabilities:                                           |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                             |   |                                | 55,886  |   |   |   |   |   |   |   | 54,402 |   |   |   |   |   |   |
| Other liabilities                                                           |   |                                | 4,447   |   |   |   |   |   |   |   | 3,208 |   |   |   |   |   |   |
| Total non-interest bearing liabilities                                      |   |                                | 60,333  |   |   |   |   |   |   |   | 57,610 |   |   |   |   |   |   |
| Stockholders’ equity                                                  |   |                                | 53,373  |   |   |   |   |   |   |   | 49,241 |   |   |   |   |   |   |
| Total Liabilities and Stockholders’                            Equity |   | $                                   | 464,791 |   |   |   |   |   |   | $ | 440,344 |   |   |   |   |   |   |
|                                                                        |   |                                |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income (tax equivalent basis)                                  |   |                                |    |   |   | 13,267 |   | 3.29 | % |   |   |   |   | 12,452 |   | 3.40 | % |
| Tax-equivalent basis adjustment                                             |   |                                |    |   |   | (398 | ) |   |   |   |   |   |   | (395 | ) |   |   |
| Net interest income                                                         |   |                                |    |   | $ | 12,869 |   |   |   |   |   |   | $ | 12,057 |   |   |   |
| Net interest margin (tax equivalent basis)                                  |   |                                |    |   |   |   |   | 3.99 | % |   |   |   |   |   |   | 3.97 | % |

 

| (1)

(2)

(3)

(4)

(5) | Interest and yields are presented on a                            tax-equivalent basis using a marginal tax rate of                            34%.

Average balances have been calculated                            based on daily balances.

Annualized.

Loan balances include non-accrual loans and are net of                            unearned income.

Loans yields inculde the effect of amortization of                            deferred fees, net of costs. |
|-------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

25

 

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**Rate/Volume Analysis**

 

The following table shows the fully taxable equivalent effect of changes            in volumes and rates on interest income and interest expense.

 

 

| **Increase/(Decrease)****Nine Months Ended September 30, 2007 Compared                            to****Nine Months Ended September 30, 2006****Variance due to** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                              |   | **Volume** |   | **Rate** |   | **Net** |   |
|                                                                                                                                                              |   | **(dollars in thousands)** |   |
| Interest earning assets:                                                                                                                                          |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                                                                                                                |   | $ | 1 |   | $ | 4 |   | $ | 5 |   |
| Interest bearing deposits with banks                                                                                                                              |   |   | 17 |   |   | 1 |   |   | 18 |   |
| Securities held to maturity                                                                                                                                       |   |   | (8 | ) |   | (1 | ) |   | (9 | ) |
| Securities available for sale:                                                                                                                                    |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                                                                                           |   |   | (67 | ) |   | 684 |   |   | 617 |   |
| Tax-exempt securities                                                                                                                                             |   |   | 53 |   |   | (1) |   |   | 52 |   |
| Total securities                                                                                                                                                  |   |   | (14 | ) |   | 683 |   |   | 669 |   |
| Loans receivable                                                                                                                                                  |   |   | 1,347 |   |   | 762 |   |   | 2,109 |   |
| Total interest earning assets                                                                                                                                     |   |   | 1,343 |   |   | 1,449 |   |   | 2,792 |   |
|                                                                                                                                                              |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                                                                                                                                     |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing demand and money market                                                                                                                          |   |   | (176 | ) |   | 288 |   |   | 112 |   |
| Savings                                                                                                                                                           |   |   | (17 | ) |   | 2 |   |   | (15 | ) |
| Time                                                                                                                                                              |   |   | 1,036 |   |   | 956 |   |   | 1,992 |   |
| Total interest bearing deposits                                                                                                                                   |   |   | 843 |   |   | 1,246 |   |   | 2,089 |   |
| Short-term borrowings                                                                                                                                             |   |   | 53 |   |   | 18 |   |   | 71 |   |
| Other borrowings                                                                                                                                                  |   |   | (126 | ) |   | (57 | ) |   | (183 | ) |
| Total interest bearing liabilities                                                                                                                                |   |   | 770 |   |   | 1,207 |   |   | 1,977 |   |
| Net interest income (tax-equivalent basis)                                                                                                                        |   | $ | 573 |   | $ | 242 |   | $ | 815 |   |
|                                                                                                                                                              |   |   |   |   |   |   |   |   |   |   |

 

 

**Comparison of Operating Results for Nine Months Ended September            30, 2007 and September 30, 2006**

 

**General**

 

Net income for the nine months ended September 30, 2007 totaled            $4,839,000, increasing $508,000, or 11.7% over the $4,331,000 earned in the similar            period in 2006. Basic and diluted earnings per share were $1.74 and $1.71,            respectively, in the 2007 period compared to $1.55 and $1.52, respectively, for the            similar period in 2006. The resulting annualized return on average

 

26

 

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assets            for the nine months ended September 30, 2007 was 1.39%, with an annualized return on            average equity of 12.12% compared to 1.31% and 11.76% for the 2006 period.

 

The following table sets forth changes in net income:

 

|                                                                             |   | **Nine Months Ended**                             |   |
|----------------------------------------------------------------------------------|--------|---------------------------------------------------|--------|
|                                                                             |   | **September 30, 2007 to**

**September 30, 2006** |   |
| **(dollars in thousands)**                                                       |   |                                              |   |
| Net income nine months ended September 30,                            2006       |   | $                                                 | 4,331  |   |
|                                                                             |   |                                              |   |   |
| Change due to:                                                                   |   |                                              |   |   |
| Net interest income                                                              |   |                                              | 812    |   |
| Provision for loan losses                                                        |   |                                              | (25)   |   |
| Net realized gains on sales of securities                                        |   |                                              | (51)   |   |
| Gains on sales of mortgage loans and servicing                            rights |   |                                              | (94)   |   |
| All other income                                                                 |   |                                              | 88     |   |
| Salaries and employee benefits                                                   |   |                                              | (23)   |   |
| All other expenses                                                               |   |                                              | (135)  |   |
| Income tax effect                                                                |   |                                              | (64    | ) |
|                                                                             |   |                                              |   |   |
| Net income nine months ended September 30,                            2007       |   | $                                                 | 4,839  |   |
|                                                                             |   |                                              |   |   |

 

**Net Interest Income**

 

Net interest income on an fte basis totaled $13,267,000 for the nine            months ended September 30, 2007, an increase of $815,000 or 6.6% over the similar            period in 2006. The fte net interest spread and net interest margin were 3.29% and            3.99%, respectively, compared to 3.40% and 3.97%, respectively, for the 2006            period.

 

Interest income (fte) totaled $22,180,000 with an average yield of 6.67%            for the nine months ended September 30, 2007, increasing from $19,388,000 and 6.18% for            the similar period in 2006. The increase was due to loan growth and an increase in the            yield on investments and loans. For the 2007 period, average loans totaled $321.8            million and represented 72.6% of average earning assets compared to $297.2 million and            71.0% of total average earning assets for the 2006 period. The average yield on loans            for the 2007 period was 7.41%, an increase of 33 basis points compared to the similar            period in 2006. The increase in yield was principally due to a higher prime rate of            interest in 2007, which averaged 8.22% compared to 7.85% for the similar period in            2006. The increase in prime rate increases the yield on the Company’s floating            rate commercial loan portfolio and on home equity lines of credit. The yield on the            securities available for sale portfolio increased 77 basis points to 4.66% for the nine            months ended September 30, 2007. The increase in principally due to lower yielding            securities maturing with the proceeds reinvested at higher yields.

 

Interest expense for the nine months ended September 30, 2007 totaled            $8,913,000 at an average cost of 3.38% increasing from $6,936,000 and 2.77% for the            similar period in 2006. As

 

27

 

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a            result of an increase in short-term interest rates, the Company increased rates paid on            money market accounts and short-term time deposits. The cost of time deposits averaged            4.58% for the current period compared to 3.75% for the similar period in 2006, as lower            costing instruments matured and were repriced at higher interest rates. The deposit mix            has also shifted to higher costing instruments with average time deposits representing            49.0% of interest-bearing liabilities in 2007 compared to 41.7% in 2006.

 

**Other Income**

 

Other income totaled $2,664,000 for the nine months ended September 30,            2007 decreasing $57,000 from $2,721,000 for the similar period in 2006. The decrease            was principally due to a lower level of gains on sales of mortgage loans and servicing            rights, $16,000 in 2007 compared to $110,000 in 2006, a decline of $94,000. This            decrease was partially offset by a $74,000 increase in income from fiduciary activities            reflecting higher estate fees and an increase in assets under management. Net realized            gains on sales of securities also decreased $51,000 for the current period compared to            2006.

 

**Other Expenses**

 

Other expenses for the nine months ended September 30, 2007 totaled            $8,495,000, an increase of $158,000, or 1.9% over the similar period in 2006. Salaries            and employee benefit costs increased $23,000 as lower ESOP expense of $444,000 was            offset by higher stock option costs of $116,000; an increase of $131,000 in 401k            expense and higher full time salary expense of $137,000. The 2007 period includes            $226,000 in costs related to the Tannersville Branch which opened in December 2006. The            Company incurred a $50,000 robbery loss and $40,000 loss related to a fraudulent check,            included in other, in the 2006 period.

             

Effective January 1, 2007, the Federal Deposit Insurance Corporation            (FDIC) created a new risk framework of four risk categories and established assessment            rates to coincide with each category. Assessment rates for Risk Category I            institutions, which includes Wayne Bank, range from 5 to 7 basis points. The FDIC also            approved a one-time assessment credit for banks in existence on December 31, 1996, that            paid a deposit insurance assessment prior to that date. Management believes that the            one-time credit will more than offset the new FDIC assessment cost for 2007. It            anticipates that the credit will be depleted in the fourth quarter of 2008.            Accordingly, Wayne Bank will begin to recognize the FDIC assessment cost at that            time.

 

**Income Tax Expense**

 

Income tax expense totaled $2,004,000 for an effective tax rate of 29.3%            for the nine months ended September 30, 2007 compared to $1,940,000 and an effective            tax rate of 30.9% for the similar period in 2006. The decrease in the effective tax            rate is principally due to higher level of tax-exempt income in the 2007.

 

28

 

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**Item 3. Quantitative and Qualitative Disclosures            about Market Risk**

 

**Market Risk**

 

Interest rate sensitivity and the repricing characteristics of assets            and liabilities are managed by the Asset and Liability Management Committee (ALCO). The            principal objective of ALCO is to maximize net interest income within acceptable levels            of risk, which are established by policy. Interest rate risk is monitored and managed            by using financial modeling techniques to measure the impact of changes in interest            rates.

 

Net interest income, which is the primary source of the Company’s            earnings, is impacted by changes in interest rates and the relationship of different            interest rates. To manage the impact of the rate changes, the balance sheet must be            structured so that repricing opportunities exist for both assets and liabilities at            approximately the same time intervals. The Company uses net interest simulation to            assist in interest rate risk management. The process includes simulating various            interest rate environments and their impact on net interest income. As of September 30,            2007, the level of net interest income at risk in a 200 basis points change in interest            rates was within the Company’s policy limits. The Company’s policy allows            for a decline of no more than 8% of net interest income.

 

Imbalance in repricing opportunities at a given point in time reflect            interest-sensitivity gaps measured as the difference between rate-sensitive assets and            rate-sensitive liabilities. These are static gap measurements that do not take into            account any future activity, and as such are principally used as early indications of            potential interest rate exposures over specific intervals.

 

As of September 30, 2007, the Bank had a positive 90 day interest            sensitivity gap of $30.5 million or 6.4% of total assets, increasing from $24 million,            5.3% of total assets as of December 31, 2006. A positive gap means that rate-sensitive            assets are greater than rate-sensitive liabilities at the time interval. This would            indicate that in a declining rate environment, the yield on interest-earning assets            would decrease faster than the cost of interest-bearing liabilities in the 90 day time            frame. However, at one year time frame, the cumulative gap is negative, at ($14.9)            million up from $(10.5) million at December 31, 2006, indicating that the Company has            opportunities to reprice liabilities downward in a declining rate environment over the            course of a year. The repricing intervals are managed by ALCO strategies, including            adjusting the average life of the investment portfolio, pricing of deposit liabilities            to attract longer or shorter term time deposits, loan pricing to encourage variable or            fixed rate products and evaluation of loan sales of long-term fixed rate            mortgages.

 

29

 

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| **September 30, 2007**                                                      |   |         |    |            |   |             |   |        |    |      |   |
|-----------------------------------------------------------------------------|--------|--------------|---------|-----------------|--------|------------------|--------|-------------|---------|-----------|--------|
| **Rate Sensitivity Table**                                                  |   |         |    |            |   |             |   |        |    |      |   |
| **(dollars in thousands)**                                                  |   |         |    |            |   |             |   |        |    |      |   |
|                                                                        |   | **3 Months** |    | **3-12 Months** |   | **1 to 3 Years** |   | **3 Years** |    | **Total** |   |
| Federal funds sold and interest bearing                            deposits |   | $            | 218     |            | $      | —          |   | $           | — |      | $      | — |   | $ | 218 |   |
| Securities                                                                  |   |         | 19,608  |            |   | 27,128           |   |        | 42,431  |      |   | 30,274 |   |   | 119,441 |   |
| Loans Receivable                                                            |   |         | 96,285  |            |   | 47,102           |   |        | 76,488  |      |   | 108,707 |   |   | 328,582 |   |
| Total RSA                                                                   |   |         | 116,111 |            |   | 74,230           |   |        | 118,919 |      |   | 138,981 |   |   | 448,241 |   |
|                                                                        |   |         |    |            |   |             |   |        |    |      |   |   |   |   |   |   |
| Non-maturity interest-bearing deposits                                      |   |         | 22,025  |            |   | 23,458           |   |        | 62,494  |      |   | 29,620 |   |   | 137,597 |   |
| Time deposits                                                               |   |         | 47,340  |            |   | 84,941           |   |        | 28,410  |      |   | 8,384 |   |   | 169,075 |   |
| Other                                                                       |   |         | 16,292  |            |   | 11,202           |   |        | 18,134  |      |   | — |   |   | 45,628 |   |
| Total RSL                                                                   |   |         | 85,657  |            |   | 119,601          |   |        | 109,038 |      |   | 38,004 |   |   | 352,300 |   |
|                                                                        |   |         |    |            |   |             |   |        |    |      |   |   |   |   |   |   |
| Interest Sensitivity Gap                                                    |   | $            | 30,454  |            | $      | (45,371          | )      | $           | 9,881   |      | $      | 100,977 |   | $ | 95,941 |   |
| Cumulative gap                                                              |   |         | 30,454  |            |   | (14,917          | )      |        | (5,036  | )         |   | 95,941 |   |   |   |   |
| RSA/RSL-Cumulative                                                          |   |         | 135.6   | %               |   | 92.7             | %      |        | 98.4    | %         |   | 127.2 | % |   |   |   |
| December 31, 2006                                                           |   |         |    |            |   |             |   |        |    |      |   |   |   |   |   |   |
| Interest Sensitivity Gap                                                    |   | $            | 23,962  |            | $      | (34,427          | )      | $           | 8,813   |      | $      | 91,169 |   | $ | 89,517 |   |
| Cumulative gap                                                              |   |         | 23,962  |            |   | (10,465          | )      |        | (1,652  | )         |   | 89,517 |   |   |   |   |
| RSA/RSL-Cumulative                                                          |   |         | 126.5   | %               |   | 94.9             | %      |        | 99.5    | %         |   | 126.3 | % |   |   |   |

 

**Item 4. Controls and Procedures**

 

The Company’s management evaluated, with the participation of the            Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness            of the Company’s disclosure controls and procedures, as of the end of the period            covered by this report. Based on that evaluation, the Chief Executive Officer and the            Chief Financial Officer concluded that the Company’s disclosure controls and            procedures are effective to ensure that information required to be disclosed by the            Company in the reports that it files or submits under the Securities Exchange Act of            1934 is recorded, processed, summarized and reported within the time periods specified            in the Securities and Exchange Commission’s rules and forms.

 

There were no changes in the Company’s internal control over            financial reporting that occurred during the Company’s last fiscal quarter that            have materially affected, or are reasonably likely to materially affect, the            Company’s internal control over financial reporting.

 

**Item 4T. Controls and Procedures**

 

See Item 4 above

 

30

 

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**PART II. OTHER INFORMATION**

 

**Item            1. Legal Proceedings**

 

Not            applicable

 

**Item 1A. Risk Factors**

 

There            have been no material changes in the risk factors affecting the Company that were            identified in Item 1A of Part I of the Company’s Form 10-K for the year ended            December 31, 2006.

 

**Item            2. Unregistered Sales of Securities and Use of            Proceeds**

 

 

|                                   |   | **Issuer Purchases of Equity Securities**  |   |
|----------------------------------------|--------|--------------------------------------------|--------|
|                                   |   | **Total number****of shares****purchased** |   | **Average price****paid per****share** |   | **Total number of****shares purchased****as part of publicly****announced plans****or programs(1)** |   | **Maximum number****of shares (or approximate****dollar value) that                            may yet****be purchased****under the plans****or programs** |   |
|                                   |   |                                       |   |   |   |   |   |   |   |
| July 1 – July 31, 2007           |   | 5,000                                      |   | $ | 31.00 |   | 5,000 |   | 60,563 |   |
| August 1 – August 31, 2007       |   | 7,000                                      |   |   | 31.10 |   | 7,000 |   | 53,563 |   |
| September 1 – September 30, 2007 |   | -                                          |   |   | - |   | - |   | 53,563 |   |
|                                   |   | 12,000                                     |   | $ | 31.06 |   | 12,000 |   | 53,563 |   |
|                                   |   |                                       |   |   |   |   |   |   |   |   |

 

(1) On            June 15, 2005, the Registrant announced its intention to repurchase up to 5% of its            outstanding common stock (approximately 140,700 shares) in the open market.

 

**Item 3. Defaults Upon Senior            Securities**

 

Not            applicable

 

31

 

----

**Item 4. Submission of Matters to a            Vote of Security Holders**

 

|   | None |
|--------|------|

 

**Item 5. Other Information**

 

None

 

**Item 6. Exhibits**

 

| (a)    |   | 3(i)   |   | Articles of Incorporation of Norwood Financial                            Corp.*                                         |
|--------|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------|
|   |   | 3(ii)  |   | Bylaws of Norwood Financial Corp.*                                                                                       |
|   |   | 4.0    |   | Specimen Stock Certificate of Norwood Financial                            Corp.*                                        |
|   |   | 10.1   |   | Amended Employment Agreement with William W. Davis,                            Jr.**                                     |
|   |   | 10.2   |   | Amended Employment Agreement with Lewis J. Critelli                            **                                        |
|   |   | 10.3   |   | Form of Change-In-Control Severance Agreement with seven                            key employees of the Bank*           |
|   |   | 10.4   |   | Wayne Bank Stock Option Plan*                                                                                            |
|   |   | 10.5   |   | Salary Continuation Agreement between the Bank and                            William W. Davis, Jr.****                  |
|   |   | 10.6   |   | Salary Continuation Agreement between the Bank and Lewis                            J. Critelli****                      |
|   |   | 10.7   |   | Salary Continuation Agreement between the Bank and                            Edward C. Kasper****                       |
|   |   | 10.8   |   | 1999 Directors Stock Compensation Plan***                                                                                |
|   |   | 10.9   |   | Salary Continuation Agreement between the Bank and                            Joseph A. Kneller****                      |
|   |   | 10.10  |   | Salary Continuation Agreement between the Bank and John                            H. Sanders****                        |
|   |   | 10.11  |   | 2006 Stock Option Plan*****                                                                                              |
|   |   | 10.12  |   | First and Second Amendments to Salary Continuation                            Agreement with William W. Davis, Jr.****** |
|   |   | 10.13  |   | First and Second Amendments to Salary Continuation                            Agreement with Lewis J. Critelli******     |
|   |   | 10.14  |   | First and Second Amendments to Salary Continuation                            Agreement with Edward C. Kasper******      |
|   |   | 10.15  |   | First and Second Amendments to Salary Continuation                            Agreement with Joseph A. Kneller******     |
|   |   | 10.16  |   | First and Second Amendments to Salary Continuation                            Agreement with John H. Sanders******       |
|   |   | 31.1   |   | Rule 13a-14(a)/15d-14(a) Certification (Chief Executive                            Officer)                              |
|   |   | 31.2   |   | Rule 13a-14(a)/15d-14(a) Certification (Chief Financial                            Officer)                              |
|   |   | 32     |   | Section 1350 Certification                                                                                               |
|   |   |   |   |                                                                                                                     |

 

 

32

 

----

___________________________

             

| * | Incorporated herein by reference to the identically                            numbered exhibits of the Registrant’s Form 10 Registration                            Statement initially filed with the Commission on April 29,                            1996. |
|---|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

| ** | Incorporated herein by reference to the identically                            numbered exhibits of the Registrant’s Form 8-K filed with the                            Commission on March 6, 2006. |
|----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

             

| *** | Incorporated herein by reference to the identically                            numbered exhibits of the Registrant’s Form 10-K filed with the                            Commission on March 20, 2000. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| **** | Incorporated herein by reference to the identically                            numbered exhibits to Registrant’s Form 10-K filed with the                            Commission on March 2, 2006. |
|------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| ***** | Incorporated herein by reference to the                            Registrant’s Form 8-K filed with the Commission on April 25,                            2006. |
|-------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| ****** | Incorporated herein by reference from the Exhibits to                            the Registrant’s Current Report on Form 8-K filed April 4,                            2006. |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

33

 

----

**Signatures**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the            registrant has duly caused this report to be signed on its behalf by the undersigned            thereunto duly authorized.

 

|                                                                           |   | **NORWOOD FINANCIAL CORP.**                     |
|--------------------------------------------------------------------------------|--------|-------------------------------------------------|
|  

                             

Date:  November 13, 2007 |   |  

                             

By: |  

                             

                            /s/ William W. Davis, Jr. |
|                                                                           |   |                                            | William W. Davis, Jr.

President and Chief Executive Officer

(Principal Executive Officer) |
|  

                             

Date:  November 13, 2007 |   |  

                             

By: |  

                             

                            /s/ Lewis J. Critelli |
|                                                                           |   |                                            | Lewis J. Critelli

Executive Vice President, Chief Operating Officer and                            Chief Financial Officer

(Principal Financial Officer) |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

34