Cardinal Bankshares Corporation and Subsidiaries

2004 Annual Report



Market for the
Companys Common Stock, Related Stockholder Matters, Stock Prices and Dividends



The Companys common stock is traded on the OTC Bulletin Board under the symbol CDBK. Some Internet sites providing stock quotations may require the use of CDBK.OB to access information about Cardinals
stock. As of December 31, 2004, the Company had issued and outstanding 1,535,733 shares of common stock which were held by approximately 706 stockholders of record.



Set forth below are the high and low (bid quotations/sales prices), known to the management of the Company, for each quarter in the last
three fiscal years.



|               |  |      |       |      |   |       |  |     |       |      |   |       |  |   |       |  |   |      
|-------------- |  | ---- | ----- | ---- | - | ----- |  | --- | ----- | ---- | - | ----- |  | - | ----- |  | - | -----
|               |  | 2004 |       | 2003 |   | 2002 
|               |  | High |       | Low  |   | High  |  | Low |       | High |   | Low  
|First Quarter  |  | $    | 25.00 |      | $ | 20.50 |  | $   | 24.25 |      | $ | 17.60 |  | $ | 17.00 |  | $ | 14.80
|Second Quarter |  |      | 21.50 |      |   | 19.95 |  |     | 20.50 |      |   | 18.75 |  |   | 23.00 |  |   | 15.25
|Third Quarter  |  |      | 21.00 |      |   | 19.90 |  |     | 21.00 |      |   | 20.00 |  |   | 23.30 |  |   | 22.50
|Fourth Quarter |  |      | 22.00 |      |   | 20.00 |  |     | 21.70 |      |   | 19.75 |  |   | 23.47 |  |   | 22.35



Cash dividends paid in 2004, 2003 and
2002, were $768 thousand, $722 thousand, and $691 thousand, respectively.



9



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Cardinal Bankshares Corporation and Subsidiaries

Selected Historical Financial Information



|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|-------------------------------------------------------- |  | ---- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | --------- | - |  | - | --------- | -
|In thousands, except share and per share data            |  | 2004 |           |   | 2003 |   |           | 2002 |  |   | 2001      |   |  | 2000 |          
|Summary of Operations                                    |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                         |  |      |           |   |     
|Interest income                                          |  | $    | 9,920     |   |      | $ | 9,874     |      |  | $ | 11,405    |   |  | $    | 12,572    |   |  | $ | 11,614    |  
|Interest expense                                         |  |      | 3,156     |   |      |   | 3,809     |      |  |   | 4,965     |   |  |      | 6,474     |   |  |   | 5,982     |  
|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net interest income                                      |  |      | 6,764     |   |      |   | 6,065     |      |  |   | 6,440     |   |  |      | 6,098     |   |  |   | 5,632     |  
|Provision for loan losses                                |  |      | 55        |   |      |   | 30        |      |  |   | 375       |   |  |      | 442       |   |  |   | 500       |  
|Noninterest income                                       |  |      | 769       |   |      |   | 874       |      |  |   | 806       |   |  |      | 594       |   |  |   | 500       |  
|Noninterest expense                                      |  |      | 4,609     |   |      |   | 4,322     |      |  |   | 3,756     |   |  |      | 3,528     |   |  |   | 3,307     |  
|Income taxes                                             |  |      | 627       |   |      |   | 562       |      |  |   | 729       |   |  |      | 632       |   |  |   | 499       |  
|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net income                                               |  | $    | 2,242     |   |      | $ | 2,025     |      |  | $ | 2,386     |   |  | $    | 2,090     |   |  | $ | 1,826     |  
|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Per Share Data1                                          |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                         |  |      |           |   |     
|Basic earnings per share                                 |  | $    | 1.46      |   |      | $ | 1.32      |      |  | $ | 1.55      |   |  | $    | 1.36      |   |  | $ | 1.22      |  
|Diluted earnings per share                               |  |      | 1.46      |   |      |   | 1.32      |      |  |   | 1.55      |   |  |      | 1.36      |   |  |   | 1.22      |  
|Cash dividends declared                                  |  |      | 0.50      |   |      |   | 0.47      |      |  |   | 0.45      |   |  |      | 0.42      |   |  |   | 0.39      |  
|Book value                                               |  |      | 16.83     |   |      |   | 15.92     |      |  |   | 15.12     |   |  |      | 13.97     |   |  |   | 12.81     |  
|                                                         |  |      |           |   |     
|Year-end Balance Sheet Summary                           |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                         |  |      |           |   |     
|Assets                                                   |  | $    | 190,591   |   |      | $ | 186,412   |      |  | $ | 189,378   |   |  | $    | 185,798   |   |  | $ | 163,240   |  
|Loans, net                                               |  |      | 123,042   |   |      |   | 119,033   |      |  |   | 113,324   |   |  |      | 113,207   |   |  |   | 92,602    |  
|Securities                                               |  |      | 41,546    |   |      |   | 40,929    |      |  |   | 45,854    |   |  |      | 45,032    |   |  |   | 57,303    |  
|Earning assets                                           |  |      | 176,393   |   |      |   | 174,502   |      |  |   | 176,798   |   |  |      | 176,402   |   |  |   | 154,883   |  
|Deposits                                                 |  |      | 161,255   |   |      |   | 159,215   |      |  |   | 165,392   |   |  |      | 163,468   |   |  |   | 143,033   |  
|Stockholders equity                                     |  |      | 25,850    |   |      |   | 24,454    |      |  |   | 23,219    |   |  |      | 21,454    |   |  |   | 19,678    |  
|Shares outstanding                                       |  |      | 1,535,733 |   |      |   | 1,535,733 |      |  |   | 1,535,733 |   |  |      | 1,535,733 |   |  |   | 1,535,733 |  
|                                                         |  |      |           |   |     
|Average Daily Balance                                    |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                         |  |      |           |   |     
|Assets                                                   |  | $    | 185,999   |   |      | $ | 188,831   |      |  | $ | 184,556   |   |  | $    | 173,600   |   |  | $ | 159,698   |  
|Loans, net                                               |  |      | 119,878   |   |      |   | 116,054   |      |  |   | 107,380   |   |  |      | 105,209   |   |  |   | 88,497    |  
|Securities                                               |  |      | 41,665    |   |      |   | 43,054    |      |  |   | 45,977    |   |  |      | 49,670    |   |  |   | 56,131    |  
|Earning assets                                           |  |      | 173,930   |   |      |   | 178,553   |      |  |   | 175,466   |   |  |      | 165,302   |   |  |   | 150,780   |  
|Deposits                                                 |  |      | 156,915   |   |      |   | 162,857   |      |  |   | 161,282   |   |  |      | 151,020   |   |  |   | 139,717   |  
|Stockholders equity                                     |  |      | 25,365    |   |      |   | 24,051    |      |  |   | 22,451    |   |  |      | 20,953    |   |  |   | 18,609    |  
|Weighted average shares outstanding                      |  |      | 1,535,733 |   |      |   | 1,535,733 |      |  |   | 1,535,733 |   |  |      | 1,535,733 |   |  |   | 1,500,927 |  
|                                                         |  |      |           |   |     
|Selected Ratios                                          |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|                                                         |  |      |           |   |     
|Return on average assets                                 |  |      | 1.21      | % |      |   | 1.07      | %    |  |   | 1.29      | % |  |      | 1.20      | % |  |   | 1.14      | %
|Return on average equity                                 |  |      | 8.84      | % |      |   | 8.42      | %    |  |   | 10.63     | % |  |      | 9.97      | % |  |   | 9.81      | %
|Dividends declared as percent of net income              |  |      | 34.25     | % |      |   | 35.61     | %    |  |   | 29.03     | % |  |      | 30.88     | % |  |   | 31.97     | %
|Net interest margin (tax-equivalent basis)               |  |      | 4.08      | % |      |   | 3.57      | %    |  |   | 3.85      | % |  |      | 3.89      | % |  |   | 3.96      | %
|Allowance for loan losses as a percentage of total loans |  |      | 1.31      | % |      |   | 1.41      | %    |  |   | 1.54      | % |  |      | 1.14      | % |  |   | 1.21      | %
|Average equity to average assets                         |  |      | 13.64     | % |      |   | 12.74     | %    |  |   | 12.16     | % |  |      | 12.07     | % |  |   | 11.65     | %
|Risk-based capital                                       |  |      | 20.74     | % |      |   | 20.37     | %    |  |   | 19.80     | % |  |      | 18.33     | % |  |   | 20.09     | %



---

|1 | Adjusted for the effects of a 3-for-1 stock split, effected in the form of a dividend, in
2001.
|- | -----------------------------------------------------------------------------------------------



10



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Cardinal Bankshares Corporation

Post Office Box 215

Floyd, Virginia 24091



To Our Shareholders, Customers and Friends:



We are pleased to present to you our Cardinal Bankshares Corporation Annual Report. Again we
experienced steady growth in 2004. It is with great pleasure that I can report that our total assets, total loans and total deposits have increased from prior year balances.



For the year ended December 31, 2004 net income for Cardinal amounted to $2,242,000, representing a 10.7% increase over prior year net
income. Basic earnings per share for 2004 were $1.46. Both represent the second best year in Cardinals history.



We were once again able to increase our cash dividend to shareholders to $.50 per common share. This represents a 6.38% increase over 2003. This also marks the
13thconsecutive year we have been able to increase cash dividends to shareholders.



Even with ever mounting regulatory, professional and taxation expenses, and the increased
competition, our ratios continue to compare very favorably to our peers.



During 2004 Cardinal opened another branch in Roanoke and moved into a new owned facility in Christiansburg. During the early part of 2005, the bank opened a branch serving the Salem, Virginia market. Our strategic plans for growth,
expansion and automation move forward and we are meeting our target goals due to the determination and hard work of our board and staff, despite the roadblocks placed in our path.



As we move on to address the challenges in 2005, we do so with steadfast optimism, commitment and drive. Our Board and staff strive to serve
our shareholders and customers. We appreciate their continued efforts. With your continued support and patronage, we will strive to meet the many goals set forth to expand our business and deliver a fair return to you, our shareholder.



Sincerely,



|                                             
|---------------------------------------------
|/s/ Leon Moore                               
|Leon Moore                                   
|Chairman, President & Chief Executive Officer









11



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LOGO



Independent Auditors Report



Board of
Directors and Stockholders

Cardinal Bankshares Corporation

Floyd, Virginia



We have audited the consolidated balance sheets of
Cardinal Bankshares Corporation and subsidiaries as of December 31, 2004 and 2003 and the related consolidated statements of income, changes in stockholders equity and cash flows for each of the three years in the period ended December 31,
2004. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with auditing standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cardinal Bankshares Corporation and subsidiaries at December 31, 2004 and 2003, and the results of
their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.



LOGO



Galax, Virginia

January 21, 2005



12



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Cardinal Bankshares Corporation and Subsidiaries

Consolidated Balance Sheets



|                                                                                                  |  |      |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|December 31, (In thousands, except share data)                                                    |  | 2004 |         |   | 2003 |  
|Assets                                                                                            |  |      |         |   |      |   |         |  
|Cash and due from banks                                                                           |  | $    | 4,162   |   |      | $ | 3,419   |  
|Interest-bearing deposits in banks                                                                |  |      | 3,602   |   |      |   | 4,316   |  
|Federal funds sold                                                                                |  |      | 7,175   |   |      |   | 9,125   |  
|Investment securities available for sale, at fair value                                           |  |      | 20,942  |   |      |   | 21,771  |  
|Investment securities held to maturity                                                            |  |      | 20,001  |   |      |   | 18,560  |  
|Restricted equity securities                                                                      |  |      | 603     |   |      |   | 598     |  
|                                                                                                  |  |     
|Total loans                                                                                       |  |      | 124,673 |   |      |   | 120,730 |  
|Allowance for loan losses                                                                         |  |      | (1,631  | ) |      |   | (1,697  | )
|                                                                                                  |  |      |         |   |      |   |         |  
|Net loans                                                                                         |  |      | 123,042 |   |      |   | 119,033 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Bank premises and equipment, net                                                                  |  |      | 4,205   |   |      |   | 2,437   |  
|Accrued interest receivable                                                                       |  |      | 933     |   |      |   | 883     |  
|Foreclosed properties                                                                             |  |      | 2       |   |      |   | 385     |  
|Bank owned life insurance                                                                         |  |      | 4,483   |   |      |   | 4,327   |  
|Other assets                                                                                      |  |      | 1,441   |   |      |   | 1,558   |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total assets                                                                                      |  | $    | 190,591 |   |      | $ | 186,412 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Liabilities and Stockholders Equity                                                              |  |      |         |   |      |   |         |  
|                                                                                                  |  |     
|Liabilities                                                                                       |  |      |         |   |      |   |         |  
|Noninterest-bearing deposits                                                                      |  | $    | 27,211  |   |      | $ | 22,959  |  
|Interest-bearing deposits                                                                         |  |      | 134,044 |   |      |   | 136,256 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total deposits                                                                                    |  |      | 161,255 |   |      |   | 159,215 |  
|                                                                                                  |  |     
|Securities sold under agreements to repurchase                                                    |  |      | 2,493   |   |      |   | 1,826   |  
|Accrued interest payable                                                                          |  |      | 110     |   |      |   | 123     |  
|Other liabilities                                                                                 |  |      | 883     |   |      |   | 794     |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total liabilities                                                                                 |  |      | 164,741 |   |      |   | 161,958 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Commitments and contingencies                                                                     |  |      |        |   |      |   |        |  
|                                                                                                  |  |     
|Stockholders equity                                                                              |  |      |         |   |      |   |         |  
|Common stock, $10 par value; 5,000,000 shares authorized; 1,535,733 shares issued and outstanding |  |      | 15,357  |   |      |   | 15,357  |  
|Additional paid-in capital                                                                        |  |      | 2,925   |   |      |   | 2,925   |  
|Retained earnings                                                                                 |  |      | 7,444   |   |      |   | 5,970   |  
|Accumulated other comprehensive income                                                            |  |      | 124     |   |      |   | 202     |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total stockholders equity                                                                        |  |      | 25,850  |   |      |   | 24,454  |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total liabilities and stockholders equity                                                        |  | $    | 190,591 |   |      | $ | 186,412 |  
|                                                                                                  |  |      |         |   |      |   |         |  



See Notes to Consolidated
Financial Statements



13



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Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Income



|                                                                         |  |      |           |      |   |           |  |   |          
|------------------------------------------------------------------------ |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|Years ended December 31, (In
thousands, except share and per share data) |  | 2004 |           | 2003 |   | 2002     
|Interest income                                                          |  |      |           |      |   |           |  |   |          
|Loans and fees on loans                                                  |  | $    | 7,971     |      | $ | 7,804     |  | $ | 8,670    
|Federal funds sold and securities purchased under agreements to resell   |  |      | 97        |      |   | 119       |  |   | 208      
|Investment securities:                                                   |  |      |           |      |   |           |  |   |          
|Taxable                                                                  |  |      | 902       |      |   | 961       |  |   | 1,434    
|Exempt from federal income tax                                           |  |      | 924       |      |   | 921       |  |   | 974      
|Deposits with banks                                                      |  |      | 26        |      |   | 69        |  |   | 119      
|                                                                         |  |      |           |      |   |           |  |   |          
|Total interest income                                                    |  |      | 9,920     |      |   | 9,874     |  |   | 11,405   
|                                                                         |  |      |           |      |   |           |  |   |          
|Interest expense                                                         |  |      |           |      |   |           |  |   |          
|Deposits                                                                 |  |      | 3,101     |      |   | 3,781     |  |   | 4,965    
|Borrowings                                                               |  |      | 55        |      |   | 28        |  |   |         
|                                                                         |  |      |           |      |   |           |  |   |          
|Total interest expense                                                   |  |      | 3,156     |      |   | 3,809     |  |   | 4,965    
|                                                                         |  |      |           |      |   |           |  |   |          
|Net interest income                                                      |  |      | 6,764     |      |   | 6,065     |  |   | 6,440    
|                                                                         |  |      |          
|Provision for loan losses                                                |  |      | 55        |      |   | 30        |  |   | 375      
|                                                                         |  |      |           |      |   |           |  |   |          
|Net interest income after provision for loan losses                      |  |      | 6,709     |      |   | 6,035     |  |   | 6,065    
|                                                                         |  |      |           |      |   |           |  |   |          
|Noninterest income                                                       |  |      |           |      |   |           |  |   |          
|Service charges on deposit accounts                                      |  |      | 267       |      |   | 308       |  |   | 312      
|Other service charges and fees                                           |  |      | 87        |      |   | 86        |  |   | 81       
|Net realized gains on sales of securities                                |  |      | 4         |      |   |          |  |   | 24       
|Income on bank owned life insurance                                      |  |      | 156       |      |   | 178       |  |   | 149      
|Other income                                                             |  |      | 255       |      |   | 302       |  |   | 240      
|                                                                         |  |      |           |      |   |           |  |   |          
|Total noninterest income                                                 |  |      | 769       |      |   | 874       |  |   | 806      
|                                                                         |  |      |           |      |   |           |  |   |          
|Noninterest expense                                                      |  |      |           |      |   |           |  |   |          
|Salaries and employee benefits                                           |  |      | 2,719     |      |   | 2,479     |  |   | 2,272    
|Occupancy and equipment                                                  |  |      | 618       |      |   | 553       |  |   | 541      
|Foreclosed assets, net                                                   |  |      | 12        |      |   | 36        |  |   | 3        
|Other operating expense                                                  |  |      | 1,260     |      |   | 1,254     |  |   | 940      
|                                                                         |  |      |           |      |   |           |  |   |          
|Total noninterest expense                                                |  |      | 4,609     |      |   | 4,322     |  |   | 3,756    
|                                                                         |  |      |           |      |   |           |  |   |          
|Income before income taxes                                               |  |      | 2,869     |      |   | 2,587     |  |   | 3,115    
|                                                                         |  |      |          
|Income tax expense                                                       |  |      | 627       |      |   | 562       |  |   | 729      
|                                                                         |  |      |           |      |   |           |  |   |          
|Net income                                                               |  | $    | 2,242     |      | $ | 2,025     |  | $ | 2,386    
|                                                                         |  |      |           |      |   |           |  |   |          
|Basic earnings per share                                                 |  | $    | 1.46      |      | $ | 1.32      |  | $ | 1.55     
|                                                                         |  |      |           |      |   |           |  |   |          
|Diluted earnings per share                                               |  | $    | 1.46      |      | $ | 1.32      |  | $ | 1.55     
|                                                                         |  |      |           |      |   |           |  |   |          
|Weighted average basic shares outstanding                                |  |      | 1,535,733 |      |   | 1,535,733 |  |   | 1,535,733
|                                                                         |  |      |           |      |   |           |  |   |          
|Weighted average diluted shares outstanding                              |  |      | 1,535,733 |      |   | 1,535,733 |  |   | 1,535,733
|                                                                         |  |      |           |      |   |           |  |   |          



See Notes to Consolidated
Financial Statements



14



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Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Changes in Stockholders Equity



|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|-------------------------------------------------------------------------------- |  | ----------- | ------ | ------------------------ | - | ---------------- |  | - | ------------------------------------------ | - |  | ----- | --- | - |  | - | ------ | -
|(In thousands)                                                                   |  | CommonStock |        | AdditionalPaid-inCapital |   | RetainedEarnings |  |   | AccumulatedOtherComprehensiveIncome (Loss) |   |  | Total |    
|Balance, December 31, 2001                                                       |  | $           | 15,357 |                          | $ | 2,925            |  | $ | 2,972                                      |   |  | $     | 200 |   |  | $ | 21,454 |  
|                                                                                 |  |             |        |                          |  
|Comprehensive income                                                             |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Net income                                                                       |  |             |       |                          |   |                 |  |   | 2,386                                      |   |  |       |    |   |  |   | 2,386  |  
|Net unrealized securities gains arising during the period, net of taxes of $44   |  |             |       |                          |   |                 |  |   |                                           |   |  |       | 86  |   |  |   | 86     |  
|Realized securities gains, net of taxes of $(8)                                  |  |             |       |                          |   |                 |  |   |                                           |   |  |       | (16 | ) |  |   | (16    | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Total comprehensive income                                                       |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   | 2,456  |  
|                                                                                 |  |             |        |                          |  
|Cash dividends declared ($0.45 per share)                                        |  |             |       |                          |   |                 |  |   | (691                                       | ) |  |       |    |   |  |   | (691   | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Balance, December 31, 2002                                                       |  |             | 15,357 |                          |   | 2,925            |  |   | 4,667                                      |   |  |       | 270 |   |  |   | 23,219 |  
|                                                                                 |  |             |        |                          |  
|Comprehensive income                                                             |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Net income                                                                       |  |             |       |                          |   |                 |  |   | 2,025                                      |   |  |       |    |   |  |   | 2,025  |  
|Net unrealized securities gains arising during the period, net of taxes of $(36) |  |             |       |                          |   |                 |  |   |                                           |   |  |       | (68 | ) |  |   | (68    | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Total comprehensive income                                                       |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   | 1,957  |  
|                                                                                 |  |             |        |                          |  
|Cash dividends declared ($0.47 per share)                                        |  |             |       |                          |   |                 |  |   | (722                                       | ) |  |       |    |   |  |   | (722   | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Balance, December 31, 2003                                                       |  |             | 15,357 |                          |   | 2,925            |  |   | 5,970                                      |   |  |       | 202 |   |  |   | 24,454 |  
|                                                                                 |  |             |        |                          |  
|Comprehensive income                                                             |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Net income                                                                       |  |             |       |                          |   |                 |  |   | 2,242                                      |   |  |       |    |   |  |   | 2,242  |  
|Net unrealized securities gains arising during the period, net of taxes of $(39) |  |             |       |                          |   |                 |  |   |                                           |   |  |       | (75 | ) |  |   | (75    | )
|Realized securities gains, net of taxes of $(1)                                  |  |             |       |                          |   |                 |  |   |                                           |   |  |       | (3  | ) |  |   | (3     | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Total comprehensive income                                                       |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   | 2,164  |  
|                                                                                 |  |             |        |                          |  
|Cash dividends declared ($0.50 per share)                                        |  |             |       |                          |   |                 |  |   | (768                                       | ) |  |       |    |   |  |   | (768   | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  
|Balance, December 31, 2004                                                       |  | $           | 15,357 |                          | $ | 2,925            |  | $ | 7,444                                      |   |  | $     | 124 |   |  | $ | 25,850 |  
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |     |   |  |   |        |  



See Notes to Consolidated
Financial Statements



15



---

Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Cash Flows



|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|----------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|Years ended December 31, (In thousands)                                 |  | 2004 |         |   | 2003 |   |         | 2002 | 
|Cash flows from operating activities                                    |  |      |         |   |      |   |         |      |  |   |         |  
|Net income                                                              |  | $    | 2,242   |   |      | $ | 2,025   |      |  | $ | 2,386   |  
|Adjustments to reconcile net income to net cash provided by operations: |  |      |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                           |  |      | 298     |   |      |   | 245     |      |  |   | 262     |  
|Accretion of discount on securities, net of amortization of premiums    |  |      | (7      | ) |      |   | 2       |      |  |   | (5      | )
|Provision for loan losses                                               |  |      | 55      |   |      |   | 30      |      |  |   | 375     |  
|Deferred income taxes                                                   |  |      | 46      |   |      |   | (32     | )    |  |   | (171    | )
|Net realized (gains) losses on securities                               |  |      | (4      | ) |      |   |        |      |  |   | (24     | )
|Net realized (gain) on sale of foreclosed assets                        |  |      | (3      | ) |      |   |        |      |  |   |        |  
|Deferred compensation and pension expense                               |  |      | 100     |   |      |   | (9      | )    |  |   | (63     | )
|Changes in assets and liabilities:                                      |  |      |         |   |      |   |         |      |  |   |         |  
|Accrued income                                                          |  |      | (50     | ) |      |   | 166     |      |  |   | 22      |  
|Other assets                                                            |  |      | (46     | ) |      |   | (101    | )    |  |   | (756    | )
|Accrued interest payable                                                |  |      | (13     | ) |      |   | (58     | )    |  |   | (117    | )
|Other liabilities                                                       |  |      | (10     | ) |      |   | 217     |      |  |   | 71      |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net cash provided by operating activities                               |  |      | 2,608   |   |      |   | 2,485   |      |  |   | 1,980   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Cash flows from investing activities                                    |  |      |         |   |      |   |         |      |  |   |         |  
|Net (increase) decrease in interest-bearing deposits in banks           |  |      | 714     |   |      |   | 3,749   |      |  |   | (7,869  | )
|Net (increase) decrease in federal funds sold                           |  |      | 1,950   |   |      |   | (475    | )    |  |   | 10,340  |  
|Purchases of investment securities                                      |  |      | (12,552 | ) |      |   | (18,332 | )    |  |   | (17,255 | )
|Sales of available for sale securities                                  |  |      | 504     |   |      |   |        |      |  |   | 2,020   |  
|Maturities of investment securities                                     |  |      | 11,329  |   |      |   | 22,885  |      |  |   | 14,548  |  
|Redemption of restricted equity securities                              |  |      | (5      | ) |      |   | 265     |      |  |   |        |  
|Net increase in loans                                                   |  |      | (4,064  | ) |      |   | (5,739  | )    |  |   | (492    | )
|Net purchases of property and equipment                                 |  |      | (2,066  | ) |      |   | (521    | )    |  |   | (120    | )
|Investment in bank owned life insurance                                 |  |      |        |   |      |   | (1,000  | )    |  |   | (3,000  | )
|Proceeds from sale of foreclosed assets                                 |  |      | 386     |   |      |   |        |      |  |   |        |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net cash provided (used) by investing activities                        |  |      | (3,804  | ) |      |   | 832     |      |  |   | (1,828  | )
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Cash flows from financing activities                                    |  |      |         |   |      |   |         |      |  |   |         |  
|Net increase in noninterest-bearing deposits                            |  |      | 4,252   |   |      |   | 1,923   |      |  |   | 929     |  
|Net increase in interest-bearing deposits                               |  |      | (2,212  | ) |      |   | (8,100  | )    |  |   | 995     |  
|Net increase in other borrowings                                        |  |      | 667     |   |      |   | 1,826   |      |  |   |        |  
|Dividends paid                                                          |  |      | (768    | ) |      |   | (722    | )    |  |   | (691    | )
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net cash provided (used) by financing activities                        |  |      | 1,939   |   |      |   | (5,073  | )    |  |   | 1,233   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                    |  |      | 743     |   |      |   | (1,756  | )    |  |   | 1,385   |  
|                                                                        |  |      |        
|Cash and cash equivalents, beginning                                    |  |      | 3,419   |   |      |   | 5,175   |      |  |   | 3,790   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents, ending                                       |  | $    | 4,162   |   |      | $ | 3,419   |      |  | $ | 5,175   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Supplemental disclosures of cash flow information                       |  |      |         |   |      |   |         |      |  |   |         |  
|Interest paid                                                           |  | $    | 3,169   |   |      | $ | 3,867   |      |  | $ | 5,082   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Income taxes paid                                                       |  | $    | 602     |   |      | $ | 581     |      |  | $ | 806     |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  



See Notes to Consolidated
Financial Statements



16



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 1. Organization and Summary of Significant Accounting Policies



Organization



Cardinal Bankshares Corporation (the Company) was incorporated as a Virginia
corporation on March 12, 1996 to acquire the stock of Bank of Floyd (the Bank). The Bank was acquired by the Company on June 30, 1996.



Bank of Floyd and its wholly-owned subsidiary, FBC, Inc., are incorporated and operate under the laws of the Commonwealth of Virginia. As a state chartered Federal
Reserve member, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions and the Federal Reserve. The Bank serves the counties of Floyd, Carroll, Montgomery, and Roanoke, Virginia and the Cities of Roanoke, Christiansburg
and Salem, Virginia, through seven banking offices. FBC, Inc.s assets and operations consist primarily of annuity sales and minority interests in an insurance company and a title insurance company.



The accounting and financial reporting policies of the Company conform to generally accepted
accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.



Principles of Consolidation



The consolidated financial statements of the Company include the accounts of the Company, the Bank and FBC, Inc. All material intercompany transactions and balances have
been eliminated.



Critical Accounting Policies



The notes to the Companys audited consolidated financial statements
contain a summary of significant accounting policies. Management believes the policies with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity. Management must make difficult and
subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could cause reported results to differ materially. These critical policies and their application
are periodically reviewed with the Audit Committee and Board of Directors.



Business Segments



The Company reports
its activities as a single business segment. In determining proper segment definition, the Company considers the materiality of the potential segment and components of the business about which financial information is available and regularly
evaluated, relative to resource allocation and performance assessment.



Advertising Expense



The Company expenses
advertising costs as they are incurred. Advertising expense for the years presented is not material to the financial statements.



Use of Estimates



The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions in the
application of certain of its accounting policies that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of the financial statements, as well as the reported amounts of
revenues and expenses during the reporting period. As a result of unanticipated events or circumstances, actual results could differ from those estimates.



Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate
acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and foreclosed real estate losses, management obtains independent appraisals for significant properties.



17



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 1. Organization and Summary of Significant Accounting Policies, continued



Use of Estimates, continued



The majority of the Companys loan portfolio consists of loans in Southwest Virginia. Accordingly, the ultimate collectibility of a substantial portion of the Companys loan portfolio and the recovery of a
substantial portion of the carrying amount of foreclosed real estate are susceptible to changes in local market conditions. The regional economy is diverse, but is influenced by the agricultural, textile and governmental segments.



While management uses available information to recognize loan and foreclosed real estate
losses, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as a part of their routine examination process, periodically review the Companys allowances for loan
and foreclosed real estate losses. Such agencies may require additions to the allowances based on their judgments about information available to them at the time of their examinations. Because of these factors, it is reasonably possible that the
allowances for loan and foreclosed real estate losses may change materially in the near term.



Cash and Cash Equivalents



For purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption cash and due from banks.



Interest-Bearing Deposits in Banks



Interest-bearing deposits in banks mature in one year and are carried at cost.



Trading Securities



The Company does not hold securities for short-term resale and therefore does not maintain a
trading securities portfolio.



Securities Held to
Maturity



Bonds, notes, and debentures for which the Company
has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity or to call dates.



Securities Available for Sale



Available for sale securities are reported at fair value and consist of bonds, notes,
debentures, and certain equity securities not classified as held to maturity securities.



Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders equity. Realized gains and losses on the sale of available
for sale securities are recorded on the trade date and are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.



Declines in the fair value of individual held to maturity and available for
sale securities below cost, that are other than temporary, are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses.



Loans Receivable



Loans receivable that management has the intent and ability to hold for the foreseeable
future or until maturity or pay-off, are reported at their outstanding principal amount adjusted for charge-offs, the allowance for loan losses, deferred fees or costs on originated loans, and unamortized premiums or discounts on purchased loans.





18



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 1. Organization and Summary of Significant Accounting Policies, continued



Loans Receivable, continued



Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the yield of the related loan. Discounts and premiums on any purchased residential real estate loans are
amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using
methods that approximate the interest method.



Interest is accrued and credited
to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in managements opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued,
all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. When facts and circumstances indicate the borrower has regained the ability to meet required payments, the loan is
returned to accrual status. Past due status of the loan is determined based on contractual terms.



Allowance for Loan Losses



The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a
loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.



The allowance for loan losses is evaluated on a regular basis by management and is based upon managements periodic review of the collectibility of the loans in light of historical experience, the nature and
volume of the loan portfolio, adverse situations that may affect the borrowers ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates
that are susceptible to significant revision as more information becomes available.



The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an
allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical
loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect managements estimate of probable losses. The unallocated component of the allowance reflects the margin of
imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.



A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal
or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest
payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking
into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrowers prior payment record, and the amount of the shortfall in relation to the principal
and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loans effective interest rate, the loans obtainable
market price, or the fair value of the collateral if the loan is collateral dependent.



Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.



19



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 1. Organization and Summary of Significant Accounting Policies, continued



Property and Equipment



Land is
carried at cost. Bank premises, furniture and equipment are carried at cost, less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives:



|                           |  |      
|-------------------------- |  | -----
|                           |  | Years
|Buildings and improvements |  | 20-40
|Furniture and equipment    |  | 5-20 



Foreclosed Properties



Real estate properties acquired through, or in lieu of, loan
foreclosure are to be sold and are initially recorded at fair value less cost to sell at the date of foreclosure. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount
or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in operations on foreclosed real estate. The historical average holding period for such properties is in excess of 23 months.



Pension Plan



A noncontributory defined benefit pension plan is provided for all employees who meet
eligibility requirements. To be eligible, an employee must be 21 years of age and have completed one year of service. Plan benefits are based on final average compensation and years of service. The plan is funded in compliance with the Employee
Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986, as amended.



Transfers of Financial Assets



Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the
transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an
agreement to repurchase them before their maturity.



Income Taxes



Provision for income taxes is based on amounts reported in the
statements of income (after exclusion of non-taxable income such as interest on state and municipal securities) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and
financial statement purposes. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or
settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.



Deferred income tax liability relating to unrealized appreciation (or the deferred tax asset in the case of unrealized depreciation) on investment securities available
for sale is recorded in other liabilities (assets). Such unrealized appreciation or depreciation is recorded as an adjustment to equity in the financial statements and not included in income determination until realized. Accordingly, the resulting
deferred income tax liability or asset is also recorded as an adjustment to equity.



Basic Earnings per Share



Basic earnings per share is
computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period, after giving retroactive effect to stock splits and stock dividends.



20



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 1. Organization and Summary of Significant Accounting Policies, continued



Diluted Earning per Share



The
computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential
common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares. For the years presented, the Company has no potentially dilutive securities
outstanding.



Comprehensive Income



Annual comprehensive income reflects the change in the Companys equity during the year
arising from transactions and events other than investments by, and distributions to, stockholders. It consists of net income plus certain other changes in assets and liabilities that are reported as separate components of stockholders equity
rather than as income or expense.



Financial Instruments



Derivatives that are used as part of the asset/liability management
process are linked to specific assets or liabilities and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. In addition, forwards and option contracts must reduce an
exposures risk, and for hedges of anticipatory transactions, the significant terms and characteristics of the transaction must be identified and the transactions must be probable of occurring. All derivative financial instruments held or
issued by the Bank are held or issued for purposes other than trading.



In the
ordinary course of business the Company has entered into off-balance-sheet financial instruments consisting of commitments to extend credit and commercial and standby letters of credit. Such financial instruments are recorded in the financial
statements when they are funded or related fees are incurred or received.



The
Company does not utilize interest-rate exchange agreements or interest-rate futures contracts.



Fair Value of Financial Instruments



Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet. In cases
where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of
future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. Statement No. 107 excludes certain
financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.



The following methods and assumptions were used by the Company in estimating its fair value
disclosures for financial instruments:



Cash and due from banks: The
carrying amounts reported in the balance sheet for these items approximate their fair values.



Interest-bearing deposits with banks:Fair values for time deposits are estimated using a discounted cash flow analysis that applies interest rates currently offered on certificates to a schedule of aggregated
contractual maturities on such time deposits.



Federal funds sold:The
carrying amounts reported in the balance sheet for these items approximate their fair values.



21



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 1. Organization and Summary of Significant Accounting Policies, continued



Fair Value of Financial Instruments, continued



Available for sale, held to maturity and restricted equity securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available. If quoted market
prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying values of restricted equity securities approximate fair values.



Loans receivable: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are
based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value
estimates include judgments regarding future expected loss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values, where applicable. The carrying amount
of accrued interest receivable approximates its fair value.



Deposit
liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow
calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits. The carrying amount of accrued interest payable approximates fair value.



Short-term and long-term debt: The carrying amounts of short-term debt approximate
their fair values. The fair values for long-term debt are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms.



Other liabilities: For fixed-rate loan commitments, fair value considers the difference between current levels of interest rates and
the committed rates. The carrying amounts of other liabilities approximates fair value.



Reclassification



Certain reclassifications have been
made to the prior years financial statements to place them on a comparable basis with the current year. Net income and stockholders equity previously reported were not affected by these reclassifications.



Recent Accounting Pronouncements



In December 2003, the FASB issued SFAS No. 132 (revised 2003), Employers
Disclosures about Pensions and Postretirement Benefits. This Statement requires additional disclosures about the assets, obligations and cash flows of defined benefit pension and postretirement plans, as well as the expense recorded for such
plans. As of December 31, 2004, the Company has disclosed the required elements related to its defined benefit pension plan in Note 9 to these consolidated financial statements.



Note 2. Restrictions on Cash and Due from Banks



To comply with banking regulations, the Company is required to maintain certain average cash reserve balances. The daily average cash
reserve requirement was approximately $1.1 million and $1.0 million for the two week periods including December 31, 2004 and 2003, respectively.



22



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 3. Securities



Debt and equity securities have been
classified in the consolidated balance sheets according to managements intent. The carrying amount of securities and their approximate fair values at December 31 follow:



|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|--------------------------------- |  | -------------- | ------ | ---------------- | - | ----------------- |  | ---------- | --- |  | - | ------
|2004 (In thousands)               |  | AmortizedCost  |        | UnrealizedGains  |   | UnrealizedLosses  |  | FairValue 
|Available for sale                |  |                |        |                  |   |                   |  |            |     |  |   |       
|U.S. Government agency securities |  | $              | 5,742  |                  | $ | 7                 |  | $          | 34  |  | $ | 5,715 
|State and municipal securities    |  |                | 2,030  |                  |   | 78                |  |            |    |  |   | 2,108 
|Mortgage-backed securities        |  |                | 11,765 |                  |   | 121               |  |            | 77  |  |   | 11,809
|Other securities                  |  |                | 1,217  |                  |   | 93                |  |            |    |  |   | 1,310 
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|                                  |  | $              | 20,754 |                  | $ | 299               |  | $          | 111 |  | $ | 20,942
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|Held to maturity                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|State and municipal securities    |  | $              | 19,457 |                  | $ | 775               |  | $          | 43  |  | $ | 20,189
|Mortgage-backed securities        |  |                | 544    |                  |   |                  |  |            | 4   |  |   | 540   
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|                                  |  | $              | 20,001 |                  | $ | 775               |  | $          | 47  |  | $ | 20,729
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|                                  |  |                |        |                 
|2003 (In thousands)               |  | Amortized Cost |        | Unrealized Gains |   | Unrealized Losses |  | Fair Value
|                                  |  |                |       
|Available for sale                |  |                |        |                  |   |                   |  |            |     |  |   |       
|U.S. Government agency securities |  | $              | 3,000  |                  | $ | 1                 |  | $          |    |  | $ | 3,001 
|State and municipal securities    |  |                | 2,029  |                  |   | 96                |  |            |    |  |   | 2,125 
|Mortgage-backed securities        |  |                | 14,454 |                  |   | 192               |  |            | 115 |  |   | 14,531
|Other securities                  |  |                | 1,982  |                  |   | 132               |  |            |    |  |   | 2,114 
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|                                  |  | $              | 21,465 |                  | $ | 421               |  | $          | 115 |  | $ | 21,771
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|Held to maturity                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|State and municipal securities    |  | $              | 17,736 |                  | $ | 1,040             |  | $          | 16  |  | $ | 18,760
|Mortgage-backed securities        |  |                | 824    |                  |   |                  |  |            | 20  |  |   | 804   
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       
|                                  |  | $              | 18,560 |                  | $ | 1,040             |  | $          | 36  |  | $ | 19,564
|                                  |  |                |        |                  |   |                   |  |            |     |  |   |       



Restricted equity securities, carried
at cost, consist of investments in stock of the Federal Home Loan Bank of Atlanta (FHLB) and The Federal Reserve of Richmond (Federal Reserve), which are upstream correspondents of the Bank. The FHLB requires financial institutions to
make equity investments in the FHLB in order to borrow from it. The Bank is required to hold that stock so long as it borrows from the FHLB. The Federal Reserve requires banks to purchase stock as a condition of membership in the Federal Reserve
system.



Investment securities with amortized cost of approximately
$14.1 million and $10.5 million at December 31, 2004 and 2003, respectively, were pledged as collateral on public deposits and for other purposes as required or permitted by law.



Gross realized gains and losses for the years ended December 31 are as follows:



|                                               |  |      |   |      |   |      |  |   |   
|---------------------------------------------- |  | ---- | - | ---- | - | ---- |  | - | --
|(In thousands)                                 |  | 2004 |   | 2003 |   | 2002
|Realized gains, available for sale securities  |  | $    | 4 |      | $ |     |  | $ | 24
|Realized losses, available for sale securities |  |      |  |      |   |     |  |   |  
|                                               |  |      |   |      |   |      |  |   |   
|                                               |  | $    | 4 |      | $ |     |  | $ | 24
|                                               |  |      |   |      |   |      |  |   |   



23



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 3. Securities, continued



The scheduled maturities of
debt securities available for sale and held to maturity at December 31, 2004, were as follows:



|                                       |  |                    |        |                  |   |                |  |            |        |  |   |       
|-------------------------------------- |  | ------------------ | ------ | ---------------- | - | -------------- |  | ---------- | ------ |  | - | ------
|                                       |  | Available for Sale |        | Held to Maturity
|(In thousands)                         |  | Amortized Cost     |        | Fair Value       |   | Amortized Cost |  | Fair Value
|                                       |  |                    |       
|Due in one year or less                |  | $                  | 12     |                  | $ | 12             |  | $          | 2,071  |  | $ | 2,097 
|Due after one year through five years  |  |                    | 5,713  |                  |   | 5,717          |  |            | 4,381  |  |   | 4,601 
|Due after five years through ten years |  |                    | 2,922  |                  |   | 2,991          |  |            | 8,092  |  |   | 8,423 
|Due after ten years                    |  |                    | 12,107 |                  |   | 12,222         |  |            | 5,457  |  |   | 5,608 
|                                       |  |                    |        |                  |   |                |  |            |        |  |   |       
|                                       |  | $                  | 20,754 |                  | $ | 20,942         |  | $          | 20,001 |  | $ | 20,729
|                                       |  |                    |        |                  |   |                |  |            |        |  |   |       



For mortgage-backed securities, the
Company reports maturities based on anticipated lives. Actual results may differ due to interest rate fluctuations.



The following table shows the unrealized losses and related fair values in the Companys held to maturity and available for sale investment securities portfolios.
This information is aggregated by investment category and by the length of time that individual securities have been in a continuous unrealized loss position at December 31, 2004.



|                                      |  |                     |       |                   |   |            |  |                   |       |            |   |                   |  |   |        |  |   |    
|------------------------------------- |  | ------------------- | ----- | ----------------- | - | ---------- |  | ----------------- | ----- | ---------- | - | ----------------- |  | - | ------ |  | - | ---
|                                      |  | Less Than 12 Months |       | 12 Months or More |   | Total     
|                                      |  | Fair Value          |       | Unrealized Losses |   | Fair Value |  | Unrealized Losses |       | Fair Value |   | Unrealized Losses
|                                      |  |                     |       |                   |   |           
|State and municipal securities        |  | $                   | 2,562 |                   | $ | 44         |  | $                 |      |            | $ |                  |  | $ | 2,562  |  | $ | 44 
|Mortgage- backed securities           |  |                     | 6,207 |                   |   | 82         |  |                   | 3,025 |            |   | 32                |  |   | 9,232  |  |   | 114
|                                      |  |                     |       |                   |   |            |  |                   |       |            |   |                   |  |   |        |  |   |    
|Total temporarily impaired securities |  | $                   | 8,769 |                   | $ | 126        |  | $                 | 3,025 |            | $ | 32                |  | $ | 11,794 |  | $ | 158
|                                      |  |                     |       |                   |   |            |  |                   |       |            |   |                   |  |   |        |  |   |    



Management considers the nature of the
investment, the underlying causes of the decline in market or fair value, the severity and duration of the decline and other evidence, on a security-by-security basis, in determining if the decline in fair value is other than temporary.



Management does not believe that the unrealized losses represent other than temporary
declines in fair value. The investments are rate sensitive and change in value in direct correlation to changes in interest rates. Management further believes the unrealized losses are not due to credit risk and will be recovered through either
accretion of discounts into income or maturity of the bonds at par value.



24



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 4. Loans Receivable



The major components of loans in the
Consolidated Balance Sheets are summarized below:



|                                                       |  |      |         |   |      |   |         |  
|------------------------------------------------------ |  | ---- | ------- | - | ---- | - | ------- | -
|December 31, (In thousands)                            |  | 2004 |         |   | 2003 |  
|Commercial                                             |  | $    | 9,728   |   |      | $ | 6,163   |  
|Real estate                                            |  |      |         |   |      |   |         |  
|Construction and land development                      |  |      | 10,111  |   |      |   | 7,212   |  
|Residential, 1-4 families                              |  |      | 30,817  |   |      |   | 30,293  |  
|Residential, 5 or more families                        |  |      | 1,987   |   |      |   | 4,880   |  
|Farmland                                               |  |      | 4,081   |   |      |   | 3,303   |  
|Nonfarm, nonresidential                                |  |      | 65,198  |   |      |   | 65,732  |  
|Agricultural                                           |  |      | 677     |   |      |   | 813     |  
|Consumer                                               |  |      | 2,397   |   |      |   | 2,568   |  
|Other                                                  |  |      | 40      |   |      |   | 93      |  
|                                                       |  |      |         |   |      |   |         |  
|Gross loans                                            |  |      | 125,036 |   |      |   | 121,057 |  
|Unearned discount and net deferred loan fees and costs |  |      | (363    | ) |      |   | (327    | )
|                                                       |  |      |         |   |      |   |         |  
|Total loans                                            |  |      | 124,673 |   |      |   | 120,730 |  
|Allowance for loan losses                              |  |      | (1,631  | ) |      |   | (1,697  | )
|                                                       |  |      |         |   |      |   |         |  
|Net loans                                              |  | $    | 123,042 |   |      | $ | 119,033 |  
|                                                       |  |      |         |   |      |   |         |  



Note 5. Allowance for Loan Losses



Changes in the allowance for loan losses are as follows:



|                                        |  |      |       |   |      |   |       |      |  |   |       |  
|--------------------------------------- |  | ---- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|Years ended December 31, (In thousands) |  | 2004 |       |   | 2003 |   |       | 2002 | 
|Balance, at January 1                   |  | $    | 1,697 |   |      | $ | 1,769 |      |  | $ | 1,300 |  
|                                        |  |      |      
|Provision charged to expense            |  |      | 55    |   |      |   | 30    |      |  |   | 375   |  
|Recoveries of amounts charged off       |  |      | 257   |   |      |   | 30    |      |  |   | 190   |  
|Amounts charged off                     |  |      | (378  | ) |      |   | (132  | )    |  |   | (96   | )
|                                        |  |      |       |   |      |   |       |      |  |   |       |  
|Balance, at December 31                 |  | $    | 1,631 |   |      | $ | 1,697 |      |  | $ | 1,769 |  
|                                        |  |      |       |   |      |   |       |      |  |   |       |  



The following is a summary of
information pertaining to impaired loans at December 31:



|                                                        |  |      |     |      |   |       |  |   |      
|------------------------------------------------------- |  | ---- | --- | ---- | - | ----- |  | - | -----
|(In thousands)                                          |  |      |     | 2004 |   | 2003 
|Impaired loans without a valuation allowance            |  |      |     |      | $ |      |  | $ |     
|Impaired loans with a valuation allowance               |  |      |     |      |   | 290   |  |   | 2,816
|                                                        |  |      |     |      |   |       |  |   |      
|Total impaired loans                                    |  |      |     |      | $ | 290   |  | $ | 2,816
|                                                        |  |      |     |      |   |       |  |   |      
|Valuation allowance related to impaired loans           |  |      |     |      | $ | 145   |  | $ | 84   
|                                                        |  |      |     |      |   |       |  |   |      
|                                                        |  |      |    
|                                                        |  | 2004 |     | 2003 |   | 2002 
|Average investment in impaired loans                    |  | $    | 252 |      | $ | 1,458 |  | $ | 18   
|                                                        |  |      |     |      |   |       |  |   |      
|Interest income recognized for the year                 |  | $    | 3   |      | $ | 67    |  | $ | 11   
|                                                        |  |      |     |      |   |       |  |   |      
|Interest income recognized on a cash basis for the year |  | $    | 3   |      | $ | 40    |  | $ | 9    
|                                                        |  |      |     |      |   |       |  |   |      



The Company is not committed to
advance additional funds in connection with impaired loans.



Nonaccrual loans
and loans past due 90 days or more at December 31, 2004, were $290 thousand and $125 thousand, respectively. At December 31, 2003, those amounts were $2.8 million and $15 thousand, respectively.



25



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 6. Bank Premises and Equipment



Bank premises and
equipment included in the Consolidated Balance Sheets are as follows:



|                                 |  |      |        |   |      |   |        |  
|-------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|December 31, (In thousands)      |  | 2004 |        |   | 2003 |  
|Land                             |  | $    | 704    |   |      | $ | 704    |  
|Bank premises                    |  |      | 4,214  |   |      |   | 2,686  |  
|Furniture and equipment          |  |      | 2,856  |   |      |   | 2,321  |  
|                                 |  |      |        |   |      |   |        |  
|Total                            |  |      | 7,774  |   |      |   | 5,711  |  
|Less accumulated depreciation    |  |      | (3,569 | ) |      |   | (3,274 | )
|                                 |  |      |        |   |      |   |        |  
|Bank premises and equipment, net |  | $    | 4,205  |   |      | $ | 2,437  |  
|                                 |  |      |        |   |      |   |        |  



The Bank has entered into long-term
leases for two of its branch banking facilities under agreements accounted for as operating leases. These leases expire between 2006 and 2009, including the exercise of renewal options ranging from three to five years. Rental expense was $29
thousand for 2004 and $9 thousand per year for 2003 and 2002. Future minimum lease payments are as follows:



|      |  |                |    
|----- |  | -------------- | ---
|      |  | (In thousands)
|2005  |  | $              | 50 
|2006  |  |                | 50 
|2007  |  |                | 52 
|2008  |  |                | 53 
|2009  |  |                | 32 
|      |  |                |    
|Total |  | $              | 237
|      |  |                |    



Note 7. Maturities of Certificates



The aggregate amount of time deposits in denominations of $100,000 or
more at December 31, 2004 and 2003 was $18.7 million and $17.1 million, respectively. At December 31, 2004, the scheduled maturities of time deposits are as follows:



|      |  |                |       
|----- |  | -------------- | ------
|      |  | (In thousands)
|2005  |  | $              | 32,809
|2006  |  |                | 20,267
|2007  |  |                | 10,957
|2008  |  |                | 12,394
|2009  |  |                | 8,708 
|      |  |                |       
|Total |  | $              | 85,135
|      |  |                |       



Note 8. Borrowings



Short-term debt consists of securities sold under agreements to repurchase, which
generally mature within one day of the transaction date. Additional information is summarized below:



|                                                       |  |      |       |   |      |   |       |  
|------------------------------------------------------ |  | ---- | ----- | - | ---- | - | ----- | -
|                                                       |  | 2004 |       |   | 2003 |  
|Outstanding balance at December 31                     |  | $    | 2,493 |   |      | $ | 1,826 |  
|                                                       |  |      |       |   |      |   |       |  
|Year-end weighted average rate                         |  |      | 2.10  | % |      |   | 2.10  | %
|                                                       |  |      |       |   |      |   |       |  
|Daily average outstanding during the period            |  | $    | 2,654 |   |      | $ | 1,263 |  
|                                                       |  |      |       |   |      |   |       |  
|Average rate for the year                              |  |      | 2.06  | % |      |   | 2.22  | %
|                                                       |  |      |       |   |      |   |       |  
|Maximum outstanding at any month-end during the period |  | $    | 4,187 |   |      | $ | 2,849 |  
|                                                       |  |      |       |   |      |   |       |  



26



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 8. Borrowings, continued



The Company has established
various credit facilities to provide additional liquidity if and as needed. These include unsecured lines of credit with correspondent banks totaling $18.2 million and a secured line of credit with the Federal Home Loan Bank of Atlanta of
approximately $22.9 million. Additional amounts are available from the Federal Home Loan Bank with additional collateral. At December 31, 2004 and 2003, there were no amounts outstanding under these agreements.



Note 9. Employee Benefit Plan



The Bank has a qualified noncontributory, defined benefit pension plan which covers
substantially all of its employees. The benefits are primarily based on years of service and earnings. The following is a summary of the plans funded status:



|                                                         |  |      |       |   |      |   |       |  
|-------------------------------------------------------- |  | ---- | ----- | - | ---- | - | ----- | -
|December 31, (In thousands)                              |  | 2004 |       |   | 2003 |  
|Change in benefit obligation                             |  |      |       |   |      |   |       |  
|Benefit obligation at beginning of year                  |  | $    | 2,517 |   |      | $ | 2,115 |  
|Service cost                                             |  |      | 167   |   |      |   | 137   |  
|Interest cost                                            |  |      | 162   |   |      |   | 148   |  
|Actuarial (gain) loss                                    |  |      | 163   |   |      |   | 166   |  
|Benefits paid                                            |  |      | (65   | ) |      |   | (49   | )
|                                                         |  |      |       |   |      |   |       |  
|Benefit obligation at end of year                        |  | $    | 2,944 |   |      | $ | 2,517 |  
|                                                         |  |      |       |   |      |   |       |  
|Change in plan assets                                    |  |      |       |   |      |   |       |  
|Fair value of plan assets at beginning of year           |  | $    | 1,848 |   |      | $ | 1,464 |  
|Actual return on plan assets                             |  |      | 196   |   |      |   | 256   |  
|Employer contribution                                    |  |      | 89    |   |      |   | 177   |  
|Benefits paid                                            |  |      | (65   | ) |      |   | (49   | )
|                                                         |  |      |       |   |      |   |       |  
|Fair value of plan assets at end of year                 |  | $    | 2,068 |   |      | $ | 1,848 |  
|                                                         |  |      |       |   |      |   |       |  
|Change in prepaid (accrued) benefit cost                 |  |      |       |   |      |   |       |  
|Prepaid (accrued) benefit cost, beginning                |  | $    | (121  | ) |      | $ | (121  | )
|Contributions                                            |  |      | 89    |   |      |   | 177   |  
|Pension cost                                             |  |      | (199  | ) |      |   | (177  | )
|                                                         |  |      |       |   |      |   |       |  
|Prepaid (accrued) benefit cost, ending                   |  | $    | (231  | ) |      | $ | (121  | )
|                                                         |  |      |       |   |      |   |       |  
|Funded status                                            |  | $    | (876  | ) |      | $ | (669  | )
|Unrecognized transitional net assets                     |  |      | (20   | ) |      |   | (24   | )
|Unrecognized prior service cost                          |  |      | 42    |   |      |   | 48    |  
|Unrecognized net actuarial (gain) loss                   |  |      | 623   |   |      |   | 524   |  
|                                                         |  |      |       |   |      |   |       |  
|Prepaid (accrued) benefit cost                           |  | $    | (231  | ) |      | $ | (121  | )
|                                                         |  |      |       |   |      |   |       |  
|Benefit obligation assumptions as of September 30        |  |      |       |   |      |   |       |  
|Discount rate                                            |  |      | 6.0   | % |      |   | 6.5   | %
|Expected return on plan assets                           |  |      | 8.5   | % |      |   | 8.5   | %
|Rate of compensation increase                            |  |      | 5.0   | % |      |   | 5.0   | %
|                                                         |  |     
|Net periodic benefit cost assumptions as of September 30 |  |      |       |   |      |   |       |  
|Discount rate                                            |  |      | 6.5   | % |      |   | 7.0   | %
|Expected return on plan assets                           |  |      | 8.5   | % |      |   | 9.0   | %
|Rate of compensation increase                            |  |      | 5.0   | % |      |   | 5.0   | %



27



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 9. Employee Benefit Plan, continued



|                                           |  |      |      |   |      |   |      |      |  |   |      |  
|------------------------------------------ |  | ---- | ---- | - | ---- | - | ---- | ---- |  | - | ---- | -
|                                           |  | 2004 |      |   | 2003 |   |      | 2002 | 
|Components of net periodic benefit cost    |  |      |      |   |      |   |      |      |  |   |      |  
|Service cost                               |  | $    | 167  |   |      | $ | 137  |      |  | $ | 113  |  
|Interest cost                              |  |      | 162  |   |      |   | 148  |      |  |   | 124  |  
|Return on plan assets                      |  |      | (196 | ) |      |   | (256 | )    |  |   | 103  |  
|Originating unrecognized asset gain (loss) |  |      | 50   |   |      |   | 131  |      |  |   | (230 | )
|Amortization                               |  |      | 2    |   |      |   | 2    |      |  |   | 2    |  
|Recognized net actuarial (gain) loss       |  |      | 14   |   |      |   | 15   |      |  |   |     |  
|                                           |  |      |      |   |      |   |      |      |  |   |      |  
|Net periodic benefit cost                  |  | $    | 199  |   |      | $ | 177  |      |  | $ | 112  |  
|                                           |  |      |      |   |      |   |      |      |  |   |      |  



Estimated future benefit payments,
which reflect expected future service, as appropriate, are as follows:



|                    |  |                |    
|------------------- |  | -------------- | ---
|                    |  | (in thousands)
|10/01/04  09/30/05 |  | $              | 34 
|10/01/05  09/30/06 |  |                | 37 
|10/01/06  09/30/07 |  |                | 108
|10/01/07  09/30/08 |  |                | 107
|10/01/08  09/30/09 |  |                | 115
|10/01/09  09/30/14 |  |                | 765



The accumulated benefit obligation for
the defined benefit pension plan was $1.9 million and $1.6 million at December 31, 2004 and 2003.



Contributions are expected to be approximately $204 thousand in 2005.



The plan sponsor selects the expected long-term rate-of-return-on-assets assumption in consultation with their investment advisors and actuary, and with concurrence from their auditors. This rate is intended to
reflect the average rate of earnings expected to be earned on the funds invested or to be invested to provide plan benefits. Historical performance is reviewed, especially with respect to real rates of return (net of inflation), for the major asset
classes held or anticipated to be held by the trust, and for the trust itself. Undue weight is not given to recent experience, that may not continue over the measurement period, with higher significance placed on current forecasts of future
long-term economic conditions.



Because assets are held in a qualified trust,
anticipated returns are not reduced for taxes. Further, solely for this purpose, the plan is assumed to continue in force and not terminate during the period during which assets are invested. However, consideration is given to the potential impact
of current and future investment policy, cash flow into and out of the trust, and expenses (both investment and non-investment) typically paid from plan assets (to the extent such expenses are not explicitly estimated within periodic cost).



The Companys defined benefit pension plans weighted-average asset
allocations at December 31, by asset category are as follows:



|                            |  |      |   |  |      |  
|--------------------------- |  | ---- | - |  | ---- | -
|                            |  | 2004 |   |  | 2003 |  
|Mutual funds  fixed income |  | 35   | % |  | 40   | %
|Mutual funds  equity       |  | 65   | % |  | 60   | %
|                            |  |      |   |  |      |  
|Total                       |  | 100  | % |  | 100  | %
|                            |  |      |   |  |      |  



28



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 9. Employee Benefit Plan, continued



The trust fund is
sufficiently diversified to maintain a reasonable level of risk without imprudently sacrificing return, with a targeted asset allocation of 40% fixed income and 60% equities. The investment advisor selects investment fund managers with demonstrated
experience and expertise, and funds with demonstrated historical performance, for the implementation of the plans investment strategy. The investment advisor will consider both actively and passively managed investment strategies and will
allocate funds across the asset classes to develop an efficient investment structure.



It is the responsibility of the trustee to administer the investments of the trust within reasonable costs, being careful to avoid sacrificing quality. These costs include, but are not limited to, management and custodial fees, consulting
fees, transaction costs and other administrative costs chargeable to the trust.



Note 10. Deferred Compensation and Life Insurance



Deferred
compensation plans have been adopted for certain members of the Board of Directors for future compensation upon retirement. Under plan provisions aggregate annual payments ranging from $2 thousand to $8 thousand are payable for ten years certain,
generally beginning at age 65. Liability accrued for compensation deferred under the plan amounts to $91 thousand and $101 thousand at December 31, 2004 and 2003, respectively.



Charges to income are based on present value of future cash payments, discounted at 8%, and amounted to $10 thousand, $7 thousand and $14
thousand for 2004, 2003 and 2002, respectively.



The Bank is owner and
beneficiary of life insurance policies on these directors. Policy cash values, net of policy loans, totaled $93 thousand and $87 thousand at December 31, 2004 and 2003, respectively.



In 2002, the Bank adopted a supplemental executive retirement plan to provide benefits for a member of management. Under plan provisions,
aggregate fixed payments of $45 thousand are payable for 20 years certain, beginning in 2007. The liability is calculated by discounting the anticipated future cash flows at 6.10%. The liability accrued for this obligation was $261 thousand and $165
thousand at December 31, 2004 and 2003, respectively. Charges to income are based on changes in the cash value of insurance which funds the liability.



Note 11. Fair Value of Financial Instruments



The estimated fair values of the Companys financial instruments are as follows:



|                                               |                |      |            |      |                |         |            |   |         |  |   |        
|---------------------------------------------- | -------------- | ---- | ---------- | ---- | -------------- | ------- | ---------- | - | ------- |  | - | -------
|December 31, (In thousands)                    |                | 2004 |            | 2003
|                                               | CarryingAmount |      | Fair Value |      | CarryingAmount |         | Fair Value
|Financial assets                               |                |      |            |      |                |         |            |   |         |  |   |        
|Cash and due from banks                        |                | $    | 4,162      |      | $              | 4,162   |            | $ | 3,419   |  | $ | 3,419  
|Interest-bearing deposits with banks           |                |      | 3,602      |      |                | 3,602   |            |   | 4,316   |  |   | 4,316  
|Federal funds sold                             |                |      | 7,175      |      |                | 7,175   |            |   | 9,125   |  |   | 9,125  
|Securities, available-for-sale                 |                |      | 20,942     |      |                | 20,942  |            |   | 21,771  |  |   | 21,771 
|Securities, held to maturity                   |                |      | 20,001     |      |                | 20,733  |            |   | 18,560  |  |   | 19,590 
|Restricted equity securities                   |                |      | 603        |      |                | 603     |            |   | 598     |  |   | 598    
|Total loans                                    |                |      | 124,673    |      |                | 123,764 |            |   | 120,730 |  |   | 121,795
|Financial liabilities                          |                |      |            |      |                |         |            |   |         |  |   |        
|Deposits                                       |                |      | 161,255    |      |                | 162,029 |            |   | 159,215 |  |   | 162,421
|Securities sold under agreements to repurchase |                |      | 2,493      |      |                | 2,493   |            |   | 1,826   |  |   | 1,826  







29



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 12. Income Taxes



The components of income tax expense
(benefit) are as follows:



|                                        |  |      |     |   |      |   |      |  |   |      |  
|--------------------------------------- |  | ---- | --- | - | ---- | - | ---- |  | - | ---- | -
|Years ended December 31, (In thousands) |  | 2004 |     |   | 2003 |   | 2002 | 
|Current taxes  federal                 |  | $    | 673 |   |      | $ | 530  |  | $ | 900  |  
|Deferred taxes  federal                |  |      | (46 | ) |      |   | 32   |  |   | (171 | )
|                                        |  |      |     |   |      |   |      |  |   |      |  
|Income tax expense                      |  | $    | 627 |   |      | $ | 562  |  | $ | 729  |  
|                                        |  |      |     |   |      |   |      |  |   |      |  



A reconciliation of the expected
income tax expense computed by applying the federal statutory rate of 34% to income included in the consolidated statements of income follows:



|                                        |  |      |      |   |      |   |      |      |  |   |       |  
|--------------------------------------- |  | ---- | ---- | - | ---- | - | ---- | ---- |  | - | ----- | -
|Years ended December 31, (In thousands) |  | 2004 |      |   | 2003 |   |      | 2002 | 
|Expected tax expense                    |  | $    | 975  |   |      | $ | 879  |      |  | $ | 1,059 |  
|Tax exempt interest                     |  |      | (328 | ) |      |   | (314 | )    |  |   | (334  | )
|Other                                   |  |      | (20  | ) |      |   | (3   | )    |  |   | 4     |  
|                                        |  |      |      |   |      |   |      |      |  |   |       |  
|Income tax expense                      |  | $    | 627  |   |      | $ | 562  |      |  | $ | 729   |  
|                                        |  |      |      |   |      |   |      |      |  |   |       |  



The tax effects of temporary timing
differences that give rise to significant portions of the net deferred tax assets and deferred tax liabilities are presented below:



|                                                             |  |      |      |   |      |   |      |  
|------------------------------------------------------------ |  | ---- | ---- | - | ---- | - | ---- | -
|December 31, (In thousands)                                  |  | 2004 |      |   | 2003 |  
|Deferred tax assets                                          |  |      |      |   |      |   |      |  
|Allowance for loan and other real estate losses              |  | $    | 456  |   |      | $ | 446  |  
|Deferred loan interest, fees                                 |  |      | 123  |   |      |   | 111  |  
|Employee benefit liabilities                                 |  |      | 253  |   |      |   | 161  |  
|Other valuation reserves                                     |  |      | 40   |   |      |   | 51   |  
|                                                             |  |      |      |   |      |   |      |  
|Total deferred tax assets                                    |  |      | 872  |   |      |   | 769  |  
|                                                             |  |      |      |   |      |   |      |  
|Deferred tax liabilities                                     |  |      |      |   |      |   |      |  
|Net unrealized appreciation on securities available for sale |  |      | (64  | ) |      |   | (104 | )
|Depreciation                                                 |  |      | (176 | ) |      |   | (116 | )
|Accretion of discount on investment securities               |  |      | (33  | ) |      |   | (36  | )
|                                                             |  |      |      |   |      |   |      |  
|Total deferred tax liabilities                               |  |      | (273 | ) |      |   | (256 | )
|                                                             |  |      |      |   |      |   |      |  
|Net deferred tax asset                                       |  | $    | 599  |   |      | $ | 513  |  
|                                                             |  |      |      |   |      |   |      |  



Note 13. Commitments and
Contingencies



Litigation



Cardinal was named as a defendant in a complaint filed by a former employee with the United
States Department of Labor under Section 806 of the Sarbanes-Oxley Act. The plaintiff alleged in his complaint that his termination in October, 2002 violated the Act. He is seeking reinstatement, back pay and damages. The Company maintains that the
independent members of Cardinals Board of Directors terminated the plaintiff lawfully because he refused to comply with the directives of the Audit Committee in their attempt to look into certain matters raised by the plaintiff. The Audit
Committee, after full investigation, later concluded that the matters raised by the plaintiff had no merit. The Boards decision was initially upheld by the Department of Labor. The plaintiff appealed that decision. The Department of Labor
Administrative Law Judge reversed the earlier decision in Cardinals favor and entered a decision in favor of the plaintiff in January 2004. Cardinal appealed that decision. The Administrative Review Board of the Department of Labor agreed to
review the decision of the Administrative Law Judge in February 2004. Their decision to review suspended the decision of the Administrative Law Judge prior to any determination of damages by the Administrative Law Judge. In May 2004, the
Administrative Review Board dismissed Cardinals petition for review without prejudice.



30



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 13. Commitments and Contingencies, continued



Litigation, continued



In June 2004,
Cardinal filed with the United States Court of Appeals for the Fourth Circuit a Petition for Review of the decisions of the United States Department of Labor. A motion to dismiss the appeal as premature was granted. The parties submitted evidence of
damages without a further hearing in December 2004 and January 2005. The Administrative Law Judge rendered a Supplemental Recommended Decision and Order in February 2005, which awarded damages to the plaintiff of $65 thousand, plus attorneys
fees of $108 thousand, and ordered the plaintiffs reinstatement. The Company immediately filed a petition for review to the Administrative Review Board of the Department of Labor. The case was accepted for review by the Administrative Review
Board on March 4th, 2005. The Companys management believes it has substantial grounds for a successful appeal
of the decision in the plaintiffs favor and will pursue appeals vigorously.



Financial Instruments with Off-Balance-Sheet Risk



The Company is 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 standby letters of
credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the consolidated balance sheets.



The Companys exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of commitments at December 31
is as follows:



|                             |  |      |        |      |   |      
|---------------------------- |  | ---- | ------ | ---- | - | -----
|December 31, (In thousands)  |  | 2004 |        | 2003
|Commitments to extend credit |  | $    | 11,759 |      | $ | 3,588
|Standby letters of credit    |  |      | 680    |      |   | 710  
|                             |  |      |        |      |   |      
|                             |  | $    | 12,439 |      | $ | 4,298
|                             |  |      |        |      |   |      



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 many of the
commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customers creditworthiness on a case-by-case basis. The amount of
collateral obtained, if deemed necessary upon extension of credit, is based on managements credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment,
residential real estate and income producing commercial properties.



Standby
letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in
issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances which the Company deems necessary.



Concentrations of Credit Risk



The majority of the Companys loans, commitments to extend credit, and standby letters
of credit have been granted to customers in the Companys market area. The majority of such customers are depositors of the Bank. Investments in state and municipal securities involve governmental entities within and outside the Companys
market area. The concentrations of credit by type of loan are set forth in the Loans Receivable note. The distribution of commitments to extend credit approximates the distribution of loans outstanding. Standby letters of credit are granted
primarily to commercial borrowers. The Company, as a matter of policy, does not extend credit to any single borrower or group of related borrowers in excess of approximately $2.5 million.





31



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 13. Commitments and Contingencies, continued



Concentrations of Credit Risk, continued



Although the Company has a reasonably diversified loan portfolio, a substantial portion of its debtors ability to honor their contracts is dependent upon economic conditions in and around Floyd, Carroll, Montgomery, and Roanoke
Counties and the Cities of Roanoke and Salem, Virginia. A significant amount of the real estate loans set forth in the Loans Receivable note are secured by commercial real estate. The Company has a loan concentration relating to nonresidential
buildings and real estate land developers. Total loans to this group amounted to approximately $26.2 million at December 31, 2004 as well as December 31, 2003.



The Company has cash and cash equivalents on deposit with financial institutions which exceed federally-insured limits.



Note 14. Regulatory Matters



Dividends



The Companys dividend payments are made from dividends received from the Bank. The
Bank, as a Virginia banking corporation, may pay dividends only out of its retained earnings. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is
necessary to ensure financial soundness of the Bank.



Intercompany
Transactions



The Banks legal lending limit on loans to
the Company are governed by Federal Reserve Act 23A, and differ from legal lending limits on loans to external customers. Generally, a bank may lend up to 10% of its capital and surplus to its Parent, if the loan is secured. If collateral is in the
form of stocks, bonds, debentures or similar obligations, it must have a market value when the loan is made of at least 20% more than the amount of the loan, and if obligations of a state or political subdivision or agency thereof, it must have a
market value of at least 10% more than the amount of the loan. If such loans are secured by obligations of the United States or agencies thereof, or by notes, drafts, bills of exchange or bankers acceptances eligible for rediscount or purchase
by a Federal Reserve Bank, requirements for collateral in excess of the loan amount do not apply. Under this definition, the legal lending limit for the Bank on loans to the Company was approximately $1.7 million at December 31, 2004. No 23A
transactions were deemed to exist between the Company and the Bank at December 31, 2004.



Capital Requirements



The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Companys and Banks financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and
classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.



Quantitative measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as
defined). Management believes, as of December 31, 2004 and 2003, that the Company and the Bank met all capital adequacy requirements to which they are subject.



32



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 14. Regulatory Matters, continued



Capital
Requirements, continued



As of December 31, 2004, the most
recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum
total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Banks category.



The Company and the Banks actual capital amounts and ratios are also presented in the
following table.



|                                       |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|-------------------------------------- |  | ------ | ------ | ----- | ------------------------------------ | - | ------ | --------------------------------------------------------------------- | ------ |  | ---- | ------ |  | ----- | ------ |  | ----- | -
|                                       |  | Actual |        |       | Minimum For CapitalAdequacy Purposes |   |        | Minimum To Be WellCapitalized UnderPrompt CorrectiveAction Provisions |       
|In thousands                           |  | Amount |        | Ratio |                                      |   | Amount |                                                                       | Ratio  |  |      | Amount |  | Ratio |       
|December 31, 2004                      |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Total capital to risk-weighted assets  |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                           |  | $      | 27,357 |       | 20.74                                | % |        | $                                                                     | 10,551 |  | 8.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                          |  |        | 19,002 |       | 15.02                                | % |        |                                                                       | 10,118 |  | 8.00 | %      |  | $     | 12,647 |  | 10.00 | %
|Tier I capital to risk-weighted assets |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                           |  |        | 25,726 |       | 19.51                                | % |        |                                                                       | 5,276  |  | 4.00 | %      |  |       | n/a    |  | n/a   | %
|Bank of Floyd                          |  |        | 17,421 |       | 13.77                                | % |        |                                                                       | 5,059  |  | 4.00 | %      |  |       | 7,588  |  | 6.00  | %
|Tier I capital to average assets       |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                           |  |        | 25,726 |       | 13.43                                | % |        |                                                                       | 7,665  |  | 4.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                          |  |        | 17,421 |       | 9.51                                 | % |        |                                                                       | 7,329  |  | 4.00 | %      |  |       | 9,161  |  | 5.00  | %
|                                       |  |        |        |       |                                      |  
|December 31, 2003                      |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Total capital to risk-weighted assets  |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                           |  | $      | 25,839 |       | 20.37                                | % |        | $                                                                     | 10,147 |  | 8.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                          |  |        | 17,279 |       | 14.21                                | % |        |                                                                       | 9,728  |  | 8.00 | %      |  | $     | 12,160 |  | 10.00 | %
|Tier I capital to risk-weighted assets |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                           |  |        | 24,252 |       | 19.12                                | % |        |                                                                       | 5,074  |  | 4.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                          |  |        | 15,759 |       | 12.96                                | % |        |                                                                       | 4,864  |  | 4.00 | %      |  |       | 7,296  |  | 6.00  | %
|Tier I capital to average assets       |  |        |        |       |                                      |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                           |  |        | 24,252 |       | 12.95                                | % |        |                                                                       | 7,490  |  | 4.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                          |  |        | 15,759 |       | 8.65                                 | % |        |                                                                       | 7,290  |  | 4.00 | %      |  |       | 9,112  |  | 5.00  | %







33



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 15. Transactions with Related Parties



The Company has
entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates
and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.



Aggregate loan transactions with related parties were as follows:



|                            |  |      |       |   |      |   |       |  
|--------------------------- |  | ---- | ----- | - | ---- | - | ----- | -
|December 31, (In thousands) |  | 2004 |       |   | 2003 |  
|Balance, beginning          |  | $    | 1,161 |   |      | $ | 1,177 |  
|                            |  |     
|Additions                   |  |      | 260   |   |      |   | 217   |  
|Repayments                  |  |      | (721  | ) |      |   | (233  | )
|                            |  |      |       |   |      |   |       |  
|Balance, ending             |  | $    | 700   |   |      | $ | 1,161 |  
|                            |  |      |       |   |      |   |       |  



Note 16. Parent Company Financial
Information



Condensed financial information of Cardinal Bankshares
Corporation is presented as follows:



Balance
Sheets



|                                                        |  |      |        |   |      |   |        |  
|------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|December 31, (In thousands)                             |  | 2004 |        |   | 2003 |  
|Assets                                                  |  |      |        |   |      |   |        |  
|Cash and due from banks                                 |  | $    | 2,991  |   |      | $ | 2,371  |  
|Investment securities available for sale, at fair value |  |      | 800    |   |      |   | 782    |  
|                                                        |  |     
|Total loans                                             |  |      | 4,375  |   |      |   | 4,455  |  
|Allowance for loan losses                               |  |      | (25    | ) |      |   | (25    | )
|                                                        |  |      |        |   |      |   |        |  
|Net loans                                               |  |      | 4,350  |   |      |   | 4,430  |  
|                                                        |  |      |        |   |      |   |        |  
|Investment in affiliate bank at equity                  |  |      | 17,502 |   |      |   | 15,930 |  
|Other assets                                            |  |      | 221    |   |      |   | 942    |  
|                                                        |  |      |        |   |      |   |        |  
|Total assets                                            |  | $    | 25,864 |   |      | $ | 24,455 |  
|                                                        |  |      |        |   |      |   |        |  
|Liabilities                                             |  |      |        |   |      |   |        |  
|Other liabilities                                       |  | $    | 14     |   |      | $ | 1      |  
|                                                        |  |      |        |   |      |   |        |  
|Total liabilities                                       |  |      | 14     |   |      |   | 1      |  
|                                                        |  |      |        |   |      |   |        |  
|Stockholders equity                                    |  |      |        |   |      |   |        |  
|Common stock                                            |  |      | 15,357 |   |      |   | 15,357 |  
|Additional paid-in capital                              |  |      | 2,925  |   |      |   | 2,925  |  
|Retained earnings                                       |  |      | 7,444  |   |      |   | 5,970  |  
|Accumulated other comprehensive income                  |  |      | 124    |   |      |   | 202    |  
|                                                        |  |      |        |   |      |   |        |  
|Total stockholders equity                              |  |      | 25,850 |   |      |   | 24,454 |  
|                                                        |  |      |        |   |      |   |        |  
|Total liabilities and stockholders equity              |  | $    | 25,864 |   |      | $ | 24,455 |  
|                                                        |  |      |        |   |      |   |        |  







34



---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



Note 16. Parent Company Financial Information, continued



Statements of Income



|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|--------------------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|Years ended December 31, (In thousands)                                                 |  | 2004 |        |   | 2003 |   |        | 2002 | 
|Income                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Dividends from affiliate bank                                                           |  | $    | 770    |   |      | $ | 722    |      |  | $ | 755    |  
|Interest on loans                                                                       |  |      | 258    |   |      |   | 210    |      |  |   | 225    |  
|Interest on investment securities                                                       |  |      | 61     |   |      |   | 61     |      |  |   | 54     |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Total income                                                                            |  |      | 1,089  |   |      |   | 993    |      |  |   | 1,034  |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Expenses                                                                                |  |      |        |   |      |   |        |      |  |   |        |  
|Management and professional fees                                                        |  |      | 550    |   |      |   | 684    |      |  |   | 280    |  
|Other expenses                                                                          |  |      | 61     |   |      |   | 94     |      |  |   | 38     |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Total expenses                                                                          |  |      | 611    |   |      |   | 778    |      |  |   | 318    |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Income before income tax benefit and equity in undistributed net income of subsidiaries |  |      | 478    |   |      |   | 215    |      |  |   | 716    |  
|                                                                                        |  |      |       
|Income tax benefit                                                                      |  |      | 102    |   |      |   | 175    |      |  |   | 5      |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Income before equity in undistributed net income of subsidiaries                        |  |      | 580    |   |      |   | 390    |      |  |   | 721    |  
|                                                                                        |  |      |       
|Equity in undistributed net income of subsidiaries                                      |  |      | 1,662  |   |      |   | 1,635  |      |  |   | 1,665  |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Net income                                                                              |  | $    | 2,242  |   |      | $ | 2,025  |      |  | $ | 2,386  |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|                                                                                        |  |      |       
|Statements of Cash Flows                                                                |  |      |        |   |      |   |        |      |  |   |        |  
|                                                                                        |  |      |       
|Years ended December 31, (In thousands)                                                 |  | 2004 |        |   | 2003 |   |        | 2002 | 
|Cash flows from operating activities                                                    |  |      |        |   |      |   |        |      |  |   |        |  
|Net income                                                                              |  | $    | 2,242  |   |      | $ | 2,025  |      |  | $ | 2,386  |  
|Adjustments to reconcile net income to net cash provided by operating activities:       |  |      |        |   |      |   |        |      |  |   |        |  
|Equity in undistributed income of subsidiaries                                          |  |      | (1,662 | ) |      |   | (1,635 | )    |  |   | (1,665 | )
|Net change in other assets                                                              |  |      | 715    |   |      |   | 395    |      |  |   | (1,286 | )
|Net change in other liabilities                                                         |  |      | 13     |   |      |   | (1     | )    |  |   | (22    | )
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Net cash provided (used) by operating activities                                        |  |      | 1,308  |   |      |   | 784    |      |  |   | (587   | )
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Cash flows from investing activities                                                    |  |      |        |   |      |   |        |      |  |   |        |  
|Net (increase) decrease in loans                                                        |  |      | 80     |   |      |   | (1,920 | )    |  |   | 560    |  
|Purchases of investment securities                                                      |  |      |       |   |      |   |       |      |  |   | (750   | )
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Net cash provided (used) by investing activities                                        |  |      | 80     |   |      |   | (1,920 | )    |  |   | (190   | )
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Cash flows from financing activities                                                    |  |      |        |   |      |   |        |      |  |   |        |  
|Dividends paid                                                                          |  |      | (768   | ) |      |   | (722   | )    |  |   | (691   | )
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Net cash used by financing activities                                                   |  |      | (768   | ) |      |   | (722   | )    |  |   | (691   | )
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Net increase (decrease) in cash and cash equivalents                                    |  |      | 620    |   |      |   | (1,858 | )    |  |   | (1,468 | )
|                                                                                        |  |      |       
|Cash and cash equivalents, beginning                                                    |  |      | 2,371  |   |      |   | 4,229  |      |  |   | 5,697  |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Cash and cash equivalents, ending                                                       |  | $    | 2,991  |   |      | $ | 2,371  |      |  | $ | 4,229  |  
|                                                                                        |  |      |        |   |      |   |        |      |  |   |        |  







35



---

Managements Discussion and Analysis



Overview



Managements Discussion and Analysis is provided to assist in the understanding and evaluation of Cardinal Bankshares Corporations financial condition and its
results of operations. The following discussion should be read in conjunction with the Corporations consolidated financial statements. Certain previously reported amounts have been reclassified to conform to current presentations.



Cardinal Bankshares Corporation, the parent company of Bank of Floyd, currently operates
seven offices in Floyd, Montgomery, Roanoke and Carroll Counties of Virginia. The main office is in Floyd with a limited service office in Willis. The Roanoke offices are in the Cave Spring and Tanglewood Mall areas of Roanoke County. The West Salem
office is located on West Main Street in Salem, Virginia. The Hillsville office is located in Carroll County on Route 52 in Hillsville, Virginia. Montgomery County is served by the branch in Christiansburg, Virginia.



The individual market conditions of each county vary from rural to urban with Floyd County
being the most rural and Roanoke the most urban. Each has its own growth pattern which varies in intensity. Bank of Floyd and bank personnel work with local, state and federal government leaders in an effort to attract business and industry to Floyd
County.



Cardinal Bankshares reported net income for the year 2004 of $2.2
million compared to $2.0 million reported in 2003. Net income per diluted share was $1.46, $.14 higher than the $1.32 reported for the prior year. The gain in net income was primarily attributable to an increase in net interest income.



Net interest income, on a taxable equivalent basis, was $7.1 million, higher by $711
thousand from $6.4 million in 2003. This increase was driven primarily by the 33 basis point reduction in average rates paid on the Companys time deposit liabilities less than $100,000. A combination of rates paid on total interest-bearing
liabilities for 2004 declining 34 basis points compared to 2003, and an 18 basis point increase in average yield on interest-earning assets contributed to the favorable increase in net interest income. Noninterest income decreased by 12.0% to $769
thousand for 2004 compared to $874 thousand for 2003. Noninterest expense increased by 6.6% to $4.6 million compared to $4.3 million in 2003, mainly due to increases in salaries and benefits expenses and occupancy and equipment expenses.



Earning assets averaged $173.9 million, compared to $178.6 million in 2003, the decrease
driven primarily by an overall decrease in the average federal funds sold balance of 26.8%. Average securities declined $1.4 million in 2004, due largely to issuer calls of U.S. Government Agency securities and paydowns on mortgage-backed
securities. Deposits in other banks decreased $4.1 million on average. The loan portfolio average increased $3.9 million in 2004, with commercial loans showing the largest gain.



Interest-bearing liabilities averaged $134.6 million, down approximately $7.5 million from 2003. Savings deposits reflected an average
increase of $2.2 million from 2003, while average time deposits and average large denomination deposits declined $6.6 million and $4.5 million, respectively.



Stockholders equity grew 5.5% to an average of $25.4 million in 2004 from $24.1 million in 2003. The return on average assets and average equity increased to 1.21%
and 8.84%, respectively for 2004 compared to 1.07% and 8.42%, respectively, for 2003. Book value per share was $16.83 at December 31, 2004, compared to $15.92 at year-end 2003, representing an increase of 5.7%.



36



---

Managements Discussion and Analysis



Table 1. Average Balances and Interest Rates (Taxable Equivalent Basis)



|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|----------------------------------------------- | --------------- | ---- | ------- | ------------------------ | ---- | ----------- | ------ | ---- | --------------- | - |  | ------------------------ | ------- | ----------- |  | - | --------------- |  | ---- | ------------------------ |  | ----------- | ------- | - |  | - | ------ |  | ---- | -
|Years ended December 31, (In
thousands)         |                 | 2004 |         |                          | 2003 |             |        | 2002 |                
|                                                | Average Balance |      |         | Interest Income/ Expense |      | Yield/ Cost |        |      | Average Balance |   |  | Interest Income/ Expense |         | Yield/ Cost |  |   | Average Balance |  |      | Interest Income/ Expense |  | Yield/ Cost |        
|                                                |                 |      |         |                          |      |             |        |     
|                                                |                 |      |         |                          |      |             |        |     
|Assets:                                         |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Interest-earning assets:                        |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Deposits in other banks                         |                 | $    | 2,236   |                          |      | $           | 26     |      | 1.18            | % |  | $                        | 6,350   |             |  | $ | 69              |  | 1.08 | %                        |  | $           | 6,707   |   |  | $ | 119    |  | 1.77 | %
|Taxable investment securities                   |                 |      | 21,345  |                          |      |             | 902    |      | 4.23            | % |  |                          | 23,549  |             |  |   | 961             |  | 4.08 | %                        |  |             | 25,880  |   |  |   | 1,434  |  | 5.54 | %
|Nontaxable investment securities                |                 |      | 20,320  |                          |      |             | 1,238  |      | 6.09            | % |  |                          | 19,505  |             |  |   | 1,234           |  | 6.32 | %                        |  |             | 20,097  |   |  |   | 1,292  |  | 6.43 | %
|Federal funds sold                              |                 |      | 8,314   |                          |      |             | 97     |      | 1.17            | % |  |                          | 11,354  |             |  |   | 119             |  | 1.05 | %                        |  |             | 13,884  |   |  |   | 208    |  | 1.50 | %
|Loans                                           |                 |      | 121,715 |                          |      |             | 7,984  |      | 6.56            | % |  |                          | 117,795 |             |  |   | 7,806           |  | 6.63 | %                        |  |             | 108,898 |   |  |   | 8,672  |  | 7.96 | %
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Total interest-earning assets                   |                 |      | 173,930 |                          |      |             | 10,247 |      | 5.89            | % |  |                          | 178,553 |             |  |   | 10,189          |  | 5.71 | %                        |  |             | 175,466 |   |  |   | 11,725 |  | 6.68 | %
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Noninterest-earning assets:                     |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Cash and due from banks                         |                 |      | 3,616   |                          |      |             |        |      |                 |   |  |                          | 3,350   |             |  |   |                 |  |      |                          |  |             | 3,027   |   |  |   |        |  |      |  
|Premises and equipment                          |                 |      | 3,404   |                          |      |             |        |      |                 |   |  |                          | 2,172   |             |  |   |                 |  |      |                          |  |             | 2,263   |   |  |   |        |  |      |  
|Other assets                                    |                 |      | 6,886   |                          |      |             |        |      |                 |   |  |                          | 6,497   |             |  |   |                 |  |      |                          |  |             | 5,318   |   |  |   |        |  |      |  
|Allowance for loan losses                       |                 |      | (1,837  | )                        |      |             |        |      |                 |   |  |                          | (1,741  | )           |  |   |                 |  |      |                          |  |             | (1,518  | ) |  |   |        |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Total assets                                    |                 | $    | 185,999 |                          |      |             |        |      |                 |   |  | $                        | 188,831 |             |  |   |                 |  |      |                          |  | $           | 184,556 |   |  |   |        |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Liabilities and stockholders equity:           |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Interest-bearing liabilities:                   |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Interest checking                               |                 | $    | 12,632  |                          |      |             | 36     |      | 0.30            | % |  | $                        | 12,637  |             |  |   | 50              |  | 0.40 | %                        |  | $           | 12,538  |   |  |   | 116    |  | 0.92 | %
|Savings deposits                                |                 |      | 37,378  |                          |      |             | 506    |      | 1.35            | % |  |                          | 35,177  |             |  |   | 562             |  | 1.60 | %                        |  |             | 29,053  |   |  |   | 675    |  | 2.32 | %
|Time deposits                                   |                 |      | 64,890  |                          |      |             | 2,070  |      | 3.19            | % |  |                          | 71,444  |             |  |   | 2,513           |  | 3.52 | %                        |  |             | 75,989  |   |  |   | 3,286  |  | 4.32 | %
|Large denomination deposits                     |                 |      | 17,075  |                          |      |             | 489    |      | 2.89            | % |  |                          | 21,531  |             |  |   | 656             |  | 3.05 | %                        |  |             | 23,518  |   |  |   | 888    |  | 3.78 | %
|Securities purchased under agreements to resell |                 |      | 2,654   |                          |      |             | 55     |      | 2.06            | % |  |                          | 1,263   |             |  |   | 28              |  | 2.22 | %                        |  |             |        |   |  |   |       |  |     |  
|Federal Home Loan Bank borrowings               |                 |      |        |                          |      |             |       |      |                | % |  |                          |        |             |  |   |                |  |     |                          |  |             |        |   |  |   |       |  |     |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Total interest-bearing liabilities              |                 |      | 134,629 |                          |      |             | 3,156  |      | 2.34            | % |  |                          | 142,052 |             |  |   | 3,809           |  | 2.68 | %                        |  |             | 141,098 |   |  |   | 4,965  |  | 3.52 | %
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Noninterest-bearing liabilities:                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Demand deposits                                 |                 |      | 24,940  |                          |      |             |        |      |                 |   |  |                          | 22,068  |             |  |   |                 |  |      |                          |  |             | 20,184  |   |  |   |        |  |      |  
|Other liabilities                               |                 |      | 1,065   |                          |      |             |        |      |                 |   |  |                          | 660     |             |  |   |                 |  |      |                          |  |             | 823     |   |  |   |        |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Total liabilities                               |                 |      | 160,634 |                          |      |             |        |      |                 |   |  |                          | 164,780 |             |  |   |                 |  |      |                          |  |             | 162,105 |   |  |   |        |  |      |  
|Stockholders equity                            |                 |      | 25,365  |                          |      |             |        |      |                 |   |  |                          | 24,051  |             |  |   |                 |  |      |                          |  |             | 22,451  |   |  |   |        |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Total liabilities and stockholders equity      |                 | $    | 185,999 |                          |      |             |        |      |                 |   |  | $                        | 188,831 |             |  |   |                 |  |      |                          |  | $           | 184,556 |   |  |   |        |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Net interest earnings                           |                 |      |         |                          |      | $           | 7,091  |      |                 |   |  |                          |         |             |  | $ | 6,380           |  |      |                          |  |             |         |   |  | $ | 6,760  |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Net interest spread (1)                         |                 |      |         |                          |      |             |        |      | 3.55            | % |  |                          |         |             |  |   |                 |  | 3.03 | %                        |  |             |         |   |  |   |        |  | 3.16 | %
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Net interest margin (2)                         |                 |      |         |                          |      |             |        |      | 4.08            | % |  |                          |         |             |  |   |                 |  | 3.57 | %                        |  |             |         |   |  |   |        |  | 3.85 | %
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  
|Taxable equivalent adjustment                   |                 |      |         |                          |      | $           | 327    |      |                 |   |  |                          |         |             |  | $ | 315             |  |      |                          |  |             |         |   |  | $ | 320    |  |      |  
|                                                |                 |      |         |                          |      |             |        |      |                 |   |  |                          |         |             |  |   |                 |  |      |                          |  |             |         |   |  |   |        |  |      |  

---

|(1) | Net interest spread is the difference between the average interest rate received on earning assets and the average interest rate paid for interest-bearing liabilities.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Net interest margin is calculated by dividing taxable equivalent net interest earnings by total average earning assets.
|--- | -----------------------------------------------------------------------------------------------------------------------

|(3) | Average loan balances include nonaccrual loans.
|--- | -----------------------------------------------







37



---

Managements Discussion and Analysis



Net Interest Income



Net interest income, the primary source of the Companys earnings, is the amount by which interest and fee income generated by earning assets exceeds the interest
paid on interest-bearing liabilities. Earning assets are comprised of loans, securities, federal funds sold and interest-bearing deposits in other banks. Interest-bearing liabilities consist of deposits, federal funds purchased and securities sold
under agreements to repurchase. The volume and the general level of interest rates among earning assets and interest-bearing liabilities effect net interest income. Table 1 shows the average balance sheets for each of the years ended December 31,
2004, 2003 and 2002. In addition, the amounts of interest earned on earning assets, with related yields, and the interest paid on interest-bearing liabilities, together with rates, are shown. Loans placed on a nonaccrual status are included in the
balances and were included in the computation of yields, upon which they had an immaterial effect. Interest on earning assets is on a taxable equivalent basis, which is computed using the federal corporate income tax rate of 34% for all three years.



Net interest income, on a taxable equivalent basis, was $7.1 million, an
increase of 11.1%, or $711 thousand from the $6.4 million in 2003. The net interest margin was 4.08% for 2004, up 51 basis points from the 3.57% reported in 2003. The overall yield on earning assets increasing 18 basis points, plus the effect of the
34 basis point drop in cost of funds supports the increase in the net interest margin.



As illustrated in Table 2, the effect of competitive pricing in loan markets of the Companys loan portfolio is evident in the $81 thousand reduction in loan interest income due to rate. The net increase in loan volume did, however,
serve to offset this decline by $259 thousand in income.



During 2004, average
federal funds sold and average interest bearing deposits held at the Federal Home Loan Bank were lowered by $7.1 million to $10.6 million due mainly to the Companys strategic reduction of rate sensitive deposit balances in light of continued
moderate loan demand in its principal market area.



Total average
interest-bearing liabilities decreased $7.5 million to $134.6 million for the year 2004. Total interest-bearing deposits declined $8.8 million to $132.0 million. The reduction in the rate sensitive liabilities or interest-bearing deposits was driven
by the strategic position taken by the Company to be less competitive on rate sensitive deposits in view of the modest loan demand in the Companys principal market area that is felt to be primarily the result of the sluggish economy.







38



---

Managements Discussion and Analysis



Table 2. Rate/Volume Variance Analysis



|                                                    |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|--------------------------------------------------- |  | --------------------- | ---- | - | -------------------------- | - | ---- | ------ |  | - | -------------------------- | - |  | ---- | ------ | - | ------ | - | ------ | - |  | - | ---- | -
|                                                    |  | 2004 Compared to 2003 |      |   | 2003 Compared to 2002      |  
|                                                    |  |                       |      |   | Increase (Decrease) Due To |   |      |        |  |   | Increase (Decrease) Due To |  
|(In thousands)                                      |  | Total                 |      |   | Rate                       |   |      | Volume |  |   | Total                      |   |  | Rate |        |   | Volume |  
|Interest-earning assets:                            |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|Deposits in other banks                             |  | $                     | (43  | ) |                            | $ | 2    |        |  | $ | (45                        | ) |  | $    | (50    | ) |        | $ | (44    | ) |  | $ | (6   | )
|Taxable investment securities                       |  |                       | (59  | ) |                            |   | 31   |        |  |   | (90                        | ) |  |      | (472   | ) |        |   | (352   | ) |  |   | (120 | )
|Nontaxable investment securities                    |  |                       | 4    |   |                            |   | (48  | )      |  |   | 52                         |   |  |      | (59    | ) |        |   | (21    | ) |  |   | (38  | )
|Federal funds sold                                  |  |                       | (22  | ) |                            |   | 10   |        |  |   | (32                        | ) |  |      | (89    | ) |        |   | (55    | ) |  |   | (34  | )
|Loans                                               |  |                       | 178  |   |                            |   | (81  | )      |  |   | 259                        |   |  |      | (866   | ) |        |   | (1,687 | ) |  |   | 821  |  
|                                                    |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|Total                                               |  |                       | 58   |   |                            |   | (86  | )      |  |   | 144                        |   |  |      | (1,536 | ) |        |   | (2,159 | ) |  |   | 623  |  
|                                                    |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|Interest-bearing liabilities:                       |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|Interest checking                                   |  |                       | (14  | ) |                            |   | (14  | )      |  |   |                           |   |  |      | (66    | ) |        |   | (67    | ) |  |   | 1    |  
|Savings deposits                                    |  |                       | (56  | ) |                            |   | (91  | )      |  |   | 35                         |   |  |      | (113   | ) |        |   | (348   | ) |  |   | 235  |  
|Time deposits                                       |  |                       | (443 | ) |                            |   | (212 | )      |  |   | (231                       | ) |  |      | (773   | ) |        |   | (585   | ) |  |   | (188 | )
|Large denomination deposits                         |  |                       | (167 | ) |                            |   | (31  | )      |  |   | (136                       | ) |  |      | (232   | ) |        |   | (161   | ) |  |   | (71  | )
|Federal Home Loan Bank borrowings                   |  |                       |     |   |                            |   |     |        |  |   |                           |   |  |      |       |   |        |   |       |   |  |   |     |  
|Securities purchased under agreements to repurchase |  |                       | 27   |   |                            |   | (3   | )      |  |   | 30                         |   |  |      | 28     |   |        |   |       |   |  |   | 28   |  
|                                                    |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|Total                                               |  |                       | (653 | ) |                            |   | (351 | )      |  |   | (302                       | ) |  |      | (1,156 | ) |        |   | (1,161 | ) |  |   | 5    |  
|                                                    |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  
|Net interest income                                 |  | $                     | 711  |   |                            | $ | 265  |        |  | $ | 446                        |   |  | $    | (380   | ) |        | $ | (998   | ) |  | $ | 618  |  
|                                                    |  |                       |      |   |                            |   |      |        |  |   |                            |   |  |      |        |   |        |   |        |   |  |   |      |  



Provision for Loan Losses



The allowance for loan losses represents the amount available for credit
losses inherent in the Companys loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. Management determines the provision for loan losses required to maintain an allowance adequate to provide for any
potential losses. The factors considered in making this decision are the collectibility of past due loans, the nature and volume of the loan portfolio, adverse situations that may affect the borrowers ability to repay, estimated value of
underlying collateral and general economic trends. In 2004, the provision for loan losses was $55 thousand, an increase of $25 thousand from the $30 thousand recorded in 2003. Based upon managements periodic reviews of the loan portfolio using
the above mentioned factors, the current year increase in the provision for loan losses was felt appropriate. Management believes the provision recorded in 2004 maintains the allowance at a level adequate to cover potential losses. The allowance for
loan losses as a percentage of total loans was 1.31% at year-end. This level is comparable to the 1.31% ratio averaged at year-end 2004 by the Companys peer group, commercial banks with assets ranging between $100 million and $300 million.
Loan charge-offs, net of recoveries, were $121 thousand for 2004, compared to net recoveries of $102 thousand for 2003. Management does not anticipate any material changes in the delinquency rates or charge-offs and recoveries in connection with its
normal lending activities.



Additional information regarding the Companys
allowance for loan losses is contained in Tables 12, 13 and 14, and in the discussion concerning Nonperforming Assets.



Noninterest Income



Noninterest income consists of revenues generated from a number of different financial services and activities. Service charges on deposit accounts including charges for insufficient funds items and fees charged for
nondeposit services make up the majority of noninterest income. Noninterest income also includes fees charged for services such as safe deposit box rentals, letters of credit, and gains realized on the sale of securities. Noninterest income totaled
$769 thousand in 2004, a decrease of $105 thousand from the $874 thousand recorded in 2003. The largest decrease in noninterest income resulted from a decrease in deposit fees and charges. The primary sources of noninterest income for the past three
years are summarized in Table 3.







39



---

Managements Discussion and Analysis



Table 3. Noninterest Income



|                                       |  |      |     |      |   |      |  |   |    
|-------------------------------------- |  | ---- | --- | ---- | - | ---- |  | - | ---
|Year ended December 31, (In thousands) |  | 2004 |     | 2003 |   | 2002
|Deposit fees and charges               |  | $    | 267 |      | $ | 308  |  | $ | 312
|Other service charges and fees         |  |      | 87  |      |   | 86   |  |   | 81 
|Gain on the sale of securities         |  |      | 4   |      |   |     |  |   | 24 
|Bank owned life insurance              |  |      | 156 |      |   | 178  |  |   | 149
|Other income                           |  |      | 255 |      |   | 302  |  |   | 240
|                                       |  |      |     |      |   |      |  |   |    
|Total noninterest income               |  | $    | 769 |      | $ | 874  |  | $ | 806
|                                       |  |      |     |      |   |      |  |   |    



Noninterest Expense



Noninterest expense was $4.6 million for 2004, an increase of $287 thousand over the $4.3
million recorded in 2003. As mentioned earlier, increased pension expense and higher salaries and benefits costs accounted for most of the year-to-year increase. Cost of living increases and higher medical insurance costs were the primary cause of
higher salary and benefits costs. Occupancy and equipment expenses accounted for most of the remaining increase.



Table 4 provides a further breakdown of noninterest expense for the past three years.



Table 4. Noninterest Expense



|                                       |  |      |       |      |   |       |  |   |      
|-------------------------------------- |  | ---- | ----- | ---- | - | ----- |  | - | -----
|Year ended December 31, (In thousands) |  | 2004 |       | 2003 |   | 2002 
|Salaries and employee benefits         |  | $    | 2,719 |      | $ | 2,479 |  | $ | 2,272
|Occupancy and equipment                |  |      | 618   |      |   | 553   |  |   | 541  
|Legal and professional                 |  |      | 432   |      |   | 528   |  |   | 189  
|Bank franchise tax                     |  |      | 112   |      |   | 114   |  |   | 110  
|Other operating expense                |  |      | 728   |      |   | 648   |  |   | 644  
|                                       |  |      |       |      |   |       |  |   |      
|Total noninterest expense              |  | $    | 4,609 |      | $ | 4,322 |  | $ | 3,756
|                                       |  |      |       |      |   |       |  |   |      



Income Taxes



Income tax expense is based on amounts reported in the statements of income, after
adjustments for non-taxable income and non-deductible expenses, and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. The deferred tax
assets and liabilities represent the future Federal income tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.



Income tax expense, substantially all Federal, was $627 thousand in 2004, $562 thousand in
2003 and $729 thousand in 2002 representing 21.9%, 21.7% and 23.4% of income before income taxes, respectively. Cardinal Bankshares deferred income tax benefits and liabilities result primarily from temporary differences in provisions for
credit losses, valuation reserves, depreciation, deferred compensation, deferred income, pension expense and investment security discount accretion.



Net deferred income tax benefits of approximately $599 thousand and $513 thousand at December 31, 2004 and 2003, respectively, are included in other assets.



40



---

Managements Discussion and Analysis



Earning Assets



In 2004, average earning assets decreased to $173.9 million, $4.7 million lower than the 2003 average of $178.6 million. Total average earning assets represented 93.5% of
total average assets in 2004. Decreases in average deposits in other banks and federal funds sold accounted primarily for the net decrease in total average earning assets of 2.6%, as other earning asset categories reflected net increases
year-to-year. Average investment securities accounted for 22.4% of total average assets, while average net loans remained the largest component of earning assets, accounting for 65.4% of total average assets in 2004, up slightly from the 62.4% level
reported in 2003. A summary of average assets for the past three years is shown below in Table 5.



Table 5. Average Asset Mix



|                                 |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|-------------------------------- | --------------- | ---- | ------- | ---- | -------------- | ---- | - | ------- | --------------- | ----- | - | - | ------- |  | -----
|December 31, (In thousands)      |                 | 2004 |         | 2003 |                | 2002
|                                 | Average Balance |      | %       |      | AverageBalance |      | % |         | Average Balance |       | %
|                                 |                 |      |         |      |               
|Interest-earning assets:         |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|Loans                            |                 | $    | 121,715 |      | 65.4           |      | $ | 117,795 |                 | 62.4  |   | $ | 108,898 |  | 59.0 
|Investment securities            |                 |      | 41,665  |      | 22.4           |      |   | 43,054  |                 | 22.8  |   |   | 45,977  |  | 24.9 
|Federal funds sold               |                 |      | 8,314   |      | 4.5            |      |   | 11,354  |                 | 6.0   |   |   | 13,884  |  | 7.5  
|Deposits in other banks          |                 |      | 2,236   |      | 1.2            |      |   | 6,350   |                 | 3.4   |   |   | 6,707   |  | 3.7  
|                                 |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|Total interest-earning assets    |                 |      | 173,930 |      | 93.5           |      |   | 178,553 |                 | 94.6  |   |   | 175,466 |  | 95.1 
|                                 |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|Noninterest-earning assets:      |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|Cash and due from banks          |                 |      | 3,616   |      | 1.9            |      |   | 3,350   |                 | 1.8   |   |   | 3,027   |  | 1.6  
|Premises and equipment           |                 |      | 3,404   |      | 1.8            |      |   | 2,172   |                 | 1.1   |   |   | 2,263   |  | 1.2  
|Other assets                     |                 |      | 5,049   |      | 2.8            |      |   | 4,756   |                 | 2.5   |   |   | 3,800   |  | 2.1  
|                                 |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|Total noninterest-earning assets |                 |      | 12,069  |      | 6.5            |      |   | 10,278  |                 | 5.4   |   |   | 9,090   |  | 4.9  
|                                 |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      
|Total assets                     |                 | $    | 185,999 |      | 100.0          |      | $ | 188,831 |                 | 100.0 |   | $ | 184,556 |  | 100.0
|                                 |                 |      |         |      |                |      |   |         |                 |       |   |   |         |  |      



Loans



Average total loans were $121.7 million for 2004, an increase of $3.9 million, or 3.3% over
2003. At December 31, 2004, the actual balance of loans secured by real estate represented the most significant portion of the loan portfolio at 90.0%. Total loans secured by 1-4 family residential properties represented 24.7% of total loans at the
end of 2004, while nonfarm/nonresidential properties made up 52.3% of total loans. These loan portfolio proportions remained relatively unchanged from year-end 2003 levels.



Loan growth will continue to be a point of focus at Cardinal for 2005. The long-range strategic objective for meeting the Companys
loan growth aspirations will be achieved through continued community involvement, expansion of the Companys market footprint, broadening of the present array of loan products offered to include conforming fixed-rate mortgage loans, home equity
lines of credit and SBA loans, and managements strengthened efforts in offering small business financing and competively-priced products. Prudent business practices and stringent internal guidelines will continue to be followed in making
lending decisions in order to balance the emphasis on loan growth with the desire to minimize exposure to loan losses.



Bank of Floyd makes both consumer and commercial loans to all neighborhoods within its market area, including the low-income and moderate-income areas. The Companys
market area is generally defined as the areas within the Virginia Counties of Floyd, Roanoke, Montgomery and Carroll, and the Cities of Roanoke, Salem and Christiansburg, Virginia. The Bank places emphasis on consumer based installment loans and
commercial loans to small and medium sized businesses. Below market pricing and competition from unregulated organizations have also been a factor when generating new loans. The amounts of loans outstanding by type at year-end 2004 and 2003, and the
maturity distribution of variable and fixed rate loans as of year-end 2004 are presented below in Table 6 and Table 7, respectively.



41



---

Managements Discussion and Analysis



Table 6. Loan Portfolio Summary



|                                         |        |      |         |   |      |       |        |  |   |         |   |  |       |  
|---------------------------------------- | ------ | ---- | ------- | - | ---- | ----- | ------ |  | - | ------- | - |  | ----- | -
|December 31, (In thousands)              |        | 2004 |         |   | 2003 |      
|                                         | Amount |      |         | % |      |       | Amount |  |   | %       |  
|Real estate construction and development |        | $    | 10,111  |   |      | 8.1   |        |  | $ | 7,212   |   |  | 6.0   |  
|Farmland                                 |        |      | 4,081   |   |      | 3.3   |        |  |   | 3,303   |   |  | 2.7   |  
|Real estate mortgage:                    |        |      |         |   |      |       |        |  |   |         |   |  |       |  
|1-4 family residential                   |        |      | 30,817  |   |      | 24.7  |        |  |   | 30,293  |   |  | 25.1  |  
|Multifamily residential                  |        |      | 1,987   |   |      | 1.6   |        |  |   | 4,880   |   |  | 4.0   |  
|Nonfarm, nonresidential                  |        |      | 65,198  |   |      | 52.3  |        |  |   | 65,732  |   |  | 54.5  |  
|                                         |        |      |         |   |      |       |        |  |   |         |   |  |       |  
|Total real estate                        |        |      | 112,194 |   |      | 90.0  |        |  |   | 111,420 |   |  | 92.3  |  
|                                         |        |      |         |  
|Agricultural                             |        |      | 677     |   |      | 0.5   |        |  |   | 813     |   |  | 0.7   |  
|Commercial and industrial                |        |      | 9,728   |   |      | 7.8   |        |  |   | 6,163   |   |  | 5.1   |  
|Consumer                                 |        |      | 2,397   |   |      | 1.9   |        |  |   | 2,568   |   |  | 2.1   |  
|Other loans                              |        |      | 40      |   |      | 0.1   |        |  |   | 63      |   |  | 0.1   |  
|Leases                                   |        |      |        |   |      | 0.0   |        |  |   | 30      |   |  | 0.0   |  
|                                         |        |      |         |   |      |       |        |  |   |         |   |  |       |  
|Gross loans                              |        |      | 125,036 |   |      |       |        |  |   | 121,057 |   |  |       |  
|Unearned income                          |        |      | (363    | ) |      | (0.3  | )      |  |   | (327    | ) |  | (0.3  | )
|                                         |        |      |         |   |      |       |        |  |   |         |   |  |       |  
|Total                                    |        | $    | 124,673 |   |      | 100.0 |        |  | $ | 120,730 |   |  | 100.0 |  
|                                         |        |      |         |   |      |       |        |  |   |         |   |  |       |  



Table 7. Loan Maturity Schedule



|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|------------------------------------ |  | ------------------------------------- | ------ | ---------------------------- | - | ------ |  | ------------ | ------- | - | - | ------- |  | -----
|                                     |  | 2004                                 
|(In thousands)                       |  | Commercial Financial and Agricultural |        | Construction and Development |   | Others |  | Total Amount |         | %
|Fixed rate loans:                    |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Within three months                  |  | $                                     | 1,654  |                              | $ | 125    |  | $            | 264     |   | $ | 2,043   |  | 1.6  
|After three but within twelve months |  |                                       | 728    |                              |   | 265    |  |              | 2,612   |   |   | 3,605   |  | 2.9  
|After one but within five years      |  |                                       | 1,563  |                              |   |       |  |              | 9,480   |   |   | 11,043  |  | 8.8  
|Over five years                      |  |                                       | 5,422  |                              |   | 2,899  |  |              | 37,031  |   |   | 45,352  |  | 36.3 
|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Total fixed rate loans               |  |                                       | 9,367  |                              |   | 3,289  |  |              | 49,387  |   |   | 62,043  |  | 49.6 
|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Variable rate loans:                 |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Within three months                  |  |                                       | 4,028  |                              |   | 4,379  |  |              | 20,515  |   |   | 28,922  |  | 23.2 
|After three but within twelve months |  |                                       | 77     |                              |   | 936    |  |              | 8,793   |   |   | 9,806   |  | 7.8  
|After one but within five years      |  |                                       | 1,014  |                              |   | 59     |  |              | 19,707  |   |   | 20,780  |  | 16.6 
|Over five years                      |  |                                       |       |                              |   | 1,448  |  |              | 2,037   |   |   | 3,485   |  | 2.8  
|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Total variable rate loans            |  |                                       | 5,119  |                              |   | 6,822  |  |              | 51,052  |   |   | 62,993  |  | 50.4 
|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Total loans:                         |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Within three months                  |  |                                       | 5,682  |                              |   | 4,504  |  |              | 20,779  |   |   | 30,965  |  | 24.8 
|After three but within twelve months |  |                                       | 805    |                              |   | 1,201  |  |              | 11,405  |   |   | 13,411  |  | 10.7 
|After one but within five years      |  |                                       | 2,577  |                              |   | 59     |  |              | 29,187  |   |   | 31,823  |  | 25.4 
|Over five years                      |  |                                       | 5,422  |                              |   | 4,347  |  |              | 39,068  |   |   | 48,837  |  | 39.1 
|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      
|Total loans                          |  | $                                     | 14,486 |                              | $ | 10,111 |  | $            | 100,439 |   | $ | 125,036 |  | 100.0
|                                     |  |                                       |        |                              |   |        |  |              |         |   |   |         |  |      





42



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Managements Discussion and Analysis



Investment Securities



The investment securities portfolio is managed to optimize the yield on excess funds while providing liquidity for unexpected deposit decreases or increased loan
generation and diversification in the overall asset management of the Company. At December 31, 2004, the Company had $20.9 million in securities available for sale, compared to $21.8 million at year-end 2003. The average yield on taxable investment
securities increased from 4.08% in 2003 to 4.23% in 2004 as a result of higher yielding securities and rising market rates of interest.



Management of the investment portfolio has always been conservative with virtually all investments taking the form of purchases of U.S. Treasury, U.S. Government
agencies, Mortgage Backed Securities and issuances of State and local bond issues. All securities are high quality and high grade. Management views the investment portfolio as a source of income, and generally purchases securities with the intent of
retaining them until maturity. However, adjustments in the portfolio are necessary from time to time to provide a source of liquidity to meet funding requirements for loan demand, deposit fluctuations and to manage interest rate risk. Accordingly,
to meet such objectives, management may sell certain securities prior to their scheduled maturity. Table 8 presents the investment portfolio at the end of 2004 by major types of investments and maturity ranges. Maturities may differ from scheduled
maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid prior to the scheduled maturity date. Maturities on all other securities are based on the earlier of the contractual maturity or the
call date, if any.



At December 31, 2004, the market value of the investment
portfolio was $41.7 million, representing a $916 thousand unrealized appreciation above amortized cost. This compared to a market value of $41.3 million and a $1.3 million unrealized appreciation above amortized cost a year earlier.



Table 8. Investment Securities



|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|------------------------------------------------------- | ----------------- | ------------------ | ----- | -------------------------- |  | - | -------------------------- | - |  | -------------- | ------ | - | ----- | ---------- | ------ | ----------- | ------------ | - | ------ | - |  | - | ------
|December 31, 2004 (In thousands)                        |                   | Amortized Cost Due |       |                            |  |   |                            |  
|                                                        | DueWithinOne Year |                    |       | After OneThroughFive Years |  |   | After FiveThroughTen Years |   |  | After TenYears |        |   | Total |            |        | MarketValue
|Investment securities                                   |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|US Government agencies and mortgage backed securities   |                   | $                  | 12    |                            |  | $ | 5,259                      |   |  | $              | 1,713  |   |       | $          | 11,067 |             |              | $ | 18,051 |   |  | $ | 18,064
|State and political subdivisions                        |                   |                    | 2,071 |                            |  |   | 4,835                      |   |  |                | 9,301  |   |       |            | 5,280  |             |              |   | 21,487 |   |  |   | 22,297
|Other securities                                        |                   |                    |      |                            |  |   |                           |   |  |                |       |   |       |            | 1,217  |             |              |   | 1,217  |   |  |   | 1,310 
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|Total                                                   |                   | $                  | 2,083 |                            |  | $ | 10,094                     |   |  | $              | 11,014 |   |       | $          | 17,564 |             |              | $ | 40,755 |   |  | $ | 41,671
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|Weighted average yields                                 |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|U.S. Government agencies and mortgage backed securities |                   |                    | 4.71  | %                          |  |   | 3.17                       | % |  |                | 4.07   | % |       |            | 4.50   | %           |              |   |        |   |  |   |       
|State and political subdivisions                        |                   |                    | 4.44  | %                          |  |   | 4.65                       | % |  |                | 4.32   | % |       |            | 4.64   | %           |              |   |        |   |  |   |       
|Other securities                                        |                   |                    |      | %                          |  |   |                           | % |  |                |       | % |       |            | 7.65   | %           |              |   |        |   |  |   |       
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|Total securities                                        |                   |                    | 4.44  | %                          |  |   | 3.88                       | % |  |                | 4.28   | % |       |            | 4.76   | %           |              |   | 4.39   | % |  |   |       
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|                                                        |                   |                    |       |                            |  |  
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       | Book Value |        |             | Market Value
|December 31, 2003 (In thousands)                        |                   |                    |       |                            |  |  
|Investment securities                                   |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|U.S. Government agencies and mortgage backed securities |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              | $ | 18,278 |   |  | $ | 18,336
|States and political subdivisions                       |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   | 19,765 |   |  |   | 20,885
|Other securities                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   | 1,982  |   |  |   | 2,114 
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       
|Total                                                   |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              | $ | 40,025 |   |  | $ | 41,335
|                                                        |                   |                    |       |                            |  |   |                            |   |  |                |        |   |       |            |        |             |              |   |        |   |  |   |       





43



---

Managements Discussion and Analysis



Deposits



Cardinal Bankshares relies on deposits generated in its market area to provide the majority of funds needed to support lending activities and for investments in liquid
assets. More specifically, core deposits (total deposits less certificates of deposits in denominations of $100,000 or more) are the primary funding source. The Companys balance sheet growth is largely determined by the availability of
deposits in the markets it serves, the cost of attracting the deposits, and the prospects of profitably utilizing the available deposits by increasing the loan or investment portfolios. The sustained low interest rate environment and other market
conditions have resulted in depositors shopping for deposit rates more than in the past. Increased customer awareness of interest rates has added to the importance of effective interest rate management. Accordingly, management must continuously
monitor market pricing, competitors rates, and internal interest rate spreads to continue the Companys growth and improve profitability. Cardinal Bankshares interest rate management goals include structuring rates in a manner that
can promote both deposit and asset growth while increasing overall profitability of the Company.



Average total deposits for the year ended December 31, 2004 declined $5.9 million to $156.9 million compared to 2003. As shown in Table 9, the Companys average interest-bearing deposits as a percent of total
average deposits decreased to 84.1% in 2004, compared to 86.5% in 2003. Average noninterest-bearing demand deposits increased to $24.9 million in 2004 from $22.1 million in 2003. Average deposits for the past three years are summarized in Table 9
below.



Table 9. Deposit Mix



|                                |                |      |         |      |                |      |   |         |                |        |   |   |         |  |       
|------------------------------- | -------------- | ---- | ------- | ---- | -------------- | ---- | - | ------- | -------------- | ------ | - | - | ------- |  | ------
|December 31, (In thousands)     |                | 2004 |         | 2003 |                | 2002
|                                | AverageBalance |      | %       |      | AverageBalance |      | % |         | AverageBalance |        | %
|Interest-bearing deposits:      |                |      |         |      |                |      |   |         |                |        |   |   |         |  |       
|Interest checking               |                | $    | 12,632  |      | 8.06           |      | $ | 12,637  |                | 7.76   |   | $ | 12,538  |  | 7.77  
|Money Market                    |                |      | 4,485   |      | 2.86           |      |   | 5,634   |                | 3.46   |   |   | 7,629   |  | 4.73  
|Savings deposits                |                |      | 32,893  |      | 20.96          |      |   | 29,543  |                | 18.14  |   |   | 21,424  |  | 13.29 
|Time deposits                   |                |      | 64,890  |      | 41.35          |      |   | 71,444  |                | 43.87  |   |   | 75,989  |  | 47.12 
|Large denomination deposits     |                |      | 17,075  |      | 10.88          |      |   | 21,531  |                | 13.22  |   |   | 23,518  |  | 14.58 
|                                |                |      |         |      |                |      |   |         |                |        |   |   |         |  |       
|Total interest-bearing deposits |                |      | 131,975 |      | 84.11          |      |   | 140,789 |                | 86.45  |   |   | 141,098 |  | 87.49 
|Noninterest-bearing deposits    |                |      | 24,940  |      | 15.89          |      |   | 22,068  |                | 13.55  |   |   | 20,184  |  | 12.51 
|                                |                |      |         |      |                |      |   |         |                |        |   |   |         |  |       
|Total deposits                  |                | $    | 156,915 |      | 100.00         |      | $ | 162,857 |                | 100.00 |   | $ | 161,282 |  | 100.00
|                                |                |      |         |      |                |      |   |         |                |        |   |   |         |  |       



The average balance of certificates of
deposit issued in denominations of $100,000 or more declined by approximately $4.4 million in 2004 as Cardinal maintained its strategy of supporting asset growth with core deposits instead of aggressively soliciting more volatile, large denomination
certificates of deposit. Table 10 provides maturity information relating to Certificates of Deposit of $100,000 or more at December 31, 2004.



Table 10. Large Denomination Deposits $100,000 and Over



Analysis of time deposits of $100,000 or more at December 31, 2004 (In thousands):



|                                        |  |   |       
|--------------------------------------- |  | - | ------
|Time remaining to maturity:             |  |   |       
|Less than three months                  |  | $ | 1,460 
|Three through one year                  |  |   | 4,266 
|Over one year                           |  |   | 12,994
|                                        |  |   |       
|Total time deposits of $100,000 or more |  | $ | 18,720
|                                        |  |   |       







44



---

Managements Discussion and Analysis



Capital Adequacy



The Companys capital serves to support asset growth and provide protection against loss to depositors and creditors. Cardinal Bankshares strives to maintain an
optimum level of capital, commensurate with its risk profile, on which an attractive return to stockholders can be realized over both the near and long term, while serving depositors, creditors and regulatory needs.



Common stock and capital surplus represents the stockholders investment in the Company
and is a key source of capital. The largest component of capital for the Company is earnings retained after payment of dividends to stockholders. Total stockholders equity was $25.9 million at December 31, 2004, an increase of $1.4 million or
5.7% compared with $24.5 million for the same period in 2003.



The FDIC has
adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted
categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0% of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain
goodwill items. Cardinal Bankshares had a ratio of total capital to risk-weighted assets of 20.74% at December 31, 2004 and a ratio of Tier 1 capital to risk-weighted assets of 19.51%. Both of these ratios well exceed the capital requirements
adopted by the federal regulatory agencies and continue to be equal to or above most of our peer group.



In addition, a minimum leverage ratio of Tier I capital to average total assets for the previous quarter is required by federal bank regulators, ranging from 3% to 5%, subject to the regulators evaluation of the
Companys overall safety and soundness. As of December 31, 2004, Cardinal Bankshares had a ratio of year-end Tier I capital to average total assets, as defined, of 13.43%.



Table 11 below sets forth summary information with respect to the capital ratios for Cardinal and the Bank at December 31, 2004. All capital
ratio levels indicate that Cardinal Bankshares and Bank of Floyd are well capitalized.



Table 11. Year-end Risk-based Capital



|                                                                                |              |      |         |               |      |   |              |   |  |               |         |   |  |   |         |  
|------------------------------------------------------------------------------- | ------------ | ---- | ------- | ------------- | ---- | - | ------------ | - |  | ------------- | ------- | - |  | - | ------- | -
|December 31, (In thousands)                                                     |              | 2004 |         |               | 2003 |  
|                                                                                | Consolidated |      |         | Bank of Floyd |      |   | Consolidated |   |  | Bank of Floyd |        
|Tier I capital                                                                  |              | $    | 25,726  |               |      | $ | 17,421       |   |  | $             | 24,252  |   |  | $ | 15,759  |  
|Qualifying allowance for loan losses (limited to 1.25% of risk-weighted assets) |              |      | 1,631   |               |      |   | 1,581        |   |  |               | 1,587   |   |  |   | 1,520   |  
|                                                                                |              |      |         |               |      |   |              |   |  |               |         |   |  |   |         |  
|Total regulatory capital                                                        |              | $    | 27,357  |               |      | $ | 19,002       |   |  | $             | 25,839  |   |  | $ | 17,279  |  
|                                                                                |              |      |         |               |      |   |              |   |  |               |         |   |  |   |         |  
|Total risk-weighted assets                                                      |              | $    | 131,890 |               |      | $ | 126,474      |   |  | $             | 126,839 |   |  | $ | 121,602 |  
|                                                                                |              |      |         |               |      |   |              |   |  |               |         |   |  |   |         |  
|Tier I as a percent of risk-weighted assets                                     |              |      | 19.51   | %             |      |   | 13.77        | % |  |               | 19.12   | % |  |   | 12.96   | %
|Total regulatory capital as a percent of risk-weighted assets                   |              |      | 20.74   | %             |      |   | 15.02        | % |  |               | 20.37   | % |  |   | 14.21   | %
|Leverage ratio*                                                                 |              |      | 13.43   | %             |      |   | 9.51         | % |  |               | 12.95   | % |  |   | 8.65    | %

---

|* | Tier I capital divided by average total assets for the quarter ended December 31.
|- | ---------------------------------------------------------------------------------



45



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Managements Discussion and Analysis



Nonperforming and Problem Assets



Certain credit risks are inherent in making loans, particularly commercial and consumer loans. Management prudently assesses these risks and strives to manage them
effectively. The Bank seeks to use shorter-term loans and, although a portion of the loans may be made based upon the value of collateral, it relies primarily on the cash flow of the borrower as the source of repayment rather than the value of the
collateral.



The Bank also manages its repayment risks by adhering to internal
credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow-up on exceptions to credit policies.



Nonperforming assets, as shown in Table 12 below, decreased to $418 thousand at December 31, 2004 from $3.2 million at December 31, 2003.
The Bank had one nonresidential note 90 days past due at the end of 2003. The note was paid up to date in 2004 and cleared from non-accrual status. Another loan that was in non-accrual at December 31, 2003 went into foreclosure. The Bank sold the
property and incurred no loss. At year-end 2004, loans past due 90 days or more had increased $110 thousand from $15 thousand a year earlier. Foreclosed assets declined to $2.0 thousand, almost 100.0% lower than the year-end 2003 level.



Table 12. Nonperforming Assets



|                               |  |      |     |      |   |      
|------------------------------ |  | ---- | --- | ---- | - | -----
|December 31 (In thousands)     |  | 2004 |     | 2003
|Nonaccrual loans               |  | $    | 291 |      | $ | 2,774
|Loans past due 90 days or more |  |      | 125 |      |   | 15   
|Foreclosed properties          |  |      | 2   |      |   | 385  
|                               |  |      |     |      |   |      
|Total nonperforming assets     |  | $    | 418 |      | $ | 3,174
|                               |  |      |     |      |   |      



Analysis of the Allowance for Loan
Losses



The allowance for loan losses represents the amount available for
credit losses inherent in the Companys loan portfolio. The Company performs periodic systematic reviews of its portfolio to identify these inherent losses, and to assess the overall probability of collection of the portfolio. These reviews
result in the identification and quantification of loss factors, which are used in determining the amount of the allowance for loan losses. In addition, the Company also evaluates the prevailing economic and business conditions affecting individual
borrowers, changes in the size and characteristics of the loan portfolio and other pertinent factors. The allowance is also subject to annual review by external auditors and regulatory examinations and determinations as to adequacy, which may take
into account such factors as the methodology used to calculate the allowance, and the size of the allowance in comparison to peer companies identified by regulatory agencies. The most recent regulatory reviews were completed in August 2001 and March
2004.



The Company is committed to the early recognition of problem loans and
to a conservative allowance. The Company believes the current allowance is adequate to cover inherent losses in the loan portfolio. However, the allowance may be increased or decreased in the future based upon managements assessment of the
factors outlined above. The allowance for loan losses was $1.6 million at December 31, 2004 and $1.7 million at December 31, 2003. The allowance as a percentage of period end loans was 1.31% at year-end 2004 and 1.41% at year-end 2003.



The provision for loan losses for the year ended December 31, 2004 was $55 thousand, an
increase of $25 thousand from the previous year. Based upon managements periodic reviews of the loan portfolio using the above mentioned factors, the current year increase in the provision was considered appropriate. Management believes the
provision recorded in 2004 maintains the allowance at a level adequate to cover potential losses.



The provision for loan losses, net charge-offs and the activity in the allowance for loan losses is detailed in Table 13.



46



---

Managements Discussion and Analysis



Table 13. Loan Losses



|                                            |  |      |       |      |   |       |  |   |       |  
|------------------------------------------- |  | ---- | ----- | ---- | - | ----- |  | - | ----- | -
|Year ended December 31, (In thousands)      |  | 2004 |       | 2003 |   | 2002  | 
|Balance at beginning of year                |  | $    | 1,697 |      | $ | 1,769 |  | $ | 1,300 |  
|Provision charged to expense                |  |      | 55    |      |   | 30    |  |   | 375   |  
|                                            |  |      |       |      |   |       |  |   |       |  
|                                            |  |      | 1,752 |      |   | 1,799 |  |   | 1,675 |  
|Loans charged off:                          |  |      |       |      |   |       |  |   |       |  
|Commercial, financial and agricultural      |  |      | 330   |      |   | 68    |  |   | 44    |  
|Real estate  residential mortgage          |  |      |      |      |   |      |  |   | 27    |  
|Real estate  construction                  |  |      |      |      |   |      |  |   |      |  
|Consumer                                    |  |      | 48    |      |   | 64    |  |   | 25    |  
|                                            |  |      |       |      |   |       |  |   |       |  
|Total charge-offs                           |  |      | 378   |      |   | 132   |  |   | 96    |  
|                                            |  |      |       |      |   |       |  |   |       |  
|Recoveries of loans previously charged off: |  |      |       |      |   |       |  |   |       |  
|Commercial, financial and agricultural      |  |      | 252   |      |   | 26    |  |   | 186   |  
|Real estate  residential mortgage          |  |      |      |      |   |      |  |   |      |  
|Real estate  construction                  |  |      |      |      |   |      |  |   |      |  
|Consumer                                    |  |      | 5     |      |   | 4     |  |   | 4     |  
|                                            |  |      |       |      |   |       |  |   |       |  
|Total recoveries                            |  |      | 257   |      |   | 30    |  |   | 190   |  
|                                            |  |      |       |      |   |       |  |   |       |  
|Net (recoveries) charge  offs              |  |      | 121   |      |   | 102   |  |   | (94   | )
|                                            |  |      |       |      |   |       |  |   |       |  
|Balance at end of year                      |  | $    | 1,631 |      | $ | 1,697 |  | $ | 1,769 |  
|                                            |  |      |       |      |   |       |  |   |       |  



The Company has allocated the
allowance for loan losses based on estimates of the allowance needed for each component of the loan portfolio. The allocation of the allowance as shown in Table 14 below should not be interpreted as an indication that loan losses in future years
will occur in the same proportions or that the allocation indicates future loan loss trends. Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories since
the total allowance is a general allowance applicable to the entire portfolio.



Table 14. Allocation of the Allowance for Loan Losses



|                                        |        |      |          |      |        |      |          |       |        |       |          |   |       |  |      
|--------------------------------------- | ------ | ---- | -------- | ---- | ------ | ---- | -------- | ----- | ------ | ----- | -------- | - | ----- |  | -----
|December 31, (In thousands)             |        | 2004 |          | 2003 |        | 2002
|                                        | Amount |      | Percent1 |      | Amount |      | Percent1 |       | Amount |       | Percent1
|Balance at end of period applicable to: |        |      |          |      |        |      |          |       |        |       |          |   |       |  |      
|Commercial, financial and agricultural  |        | $    | 620      |      | 63.7   |      | $        | 1,013 |        | 62.8  |          | $ | 502   |  | 66.6 
|Real estate, construction               |        |      | 78       |      | 8.1    |      |          | 69    |        | 6.0   |          |   | 65    |  | 1.9  
|Real estate, mortgage                   |        |      | 689      |      | 26.3   |      |          | 569   |        | 29.1  |          |   | 657   |  | 28.7 
|Consumer loans                          |        |      | 244      |      | 1.9    |      |          | 46    |        | 2.1   |          |   | 510   |  | 2.7  
|Leases                                  |        |      |         |      |       |      |          |      |        |      |          |   | 35    |  | 0.1  
|                                        |        |      |          |      |        |      |          |       |        |       |          |   |       |  |      
|Total                                   |        | $    | 1,631    |      | 100.0  |      | $        | 1,697 |        | 100.0 |          | $ | 1,769 |  | 100.0
|                                        |        |      |          |      |        |      |          |       |        |       |          |   |       |  |      

---

|(1) | Represents the percentage of loans in each category to the total loans outstanding.
|--- | -----------------------------------------------------------------------------------



Liquidity and Interest Rate Sensitivity



The principal goals of the Companys asset and liability management strategy are the
maintenance of adequate liquidity and the management of interest rate risk. Liquidity is the ability to convert assets to cash to fund depositors withdrawals or borrowers loans without significant loss. Interest rate risk management
seeks to balance the effects of interest rate changes on assets that earn interest or liabilities on which interest is paid, to protect the Company from wide fluctuations in its net interest income.



47



---

Managements Discussion and Analysis



Management must insure that adequate funds are available at all times to meet the needs of its customers. On the asset side of the balance
sheet, maturing investments, loan payments, maturing loans, federal funds sold, and unpledged investment securities are principal sources of liquidity. On the liability side of the balance sheet, liquidity sources include core deposits, the ability
to increase large denomination certificates, federal funds lines from correspondent banks, borrowings from the Federal Reserve Bank and the Federal Home Loan Bank, as well as the ability to generate funds through the issuance of long-term debt and
equity.



The liquidity ratio, the level of liquid assets divided by total
deposits plus short-term liabilities, is considered to be adequate by management.



Table 15. Interest Rate Sensitivity



|                                                 |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|------------------------------------------------ |  | -------------------------------------- | ------- | -- | ----------- | - | ------- | ------------ |  | - | -------------- | -- |  | ----- | ------ | - |  | - | ------- | -
|                                                 |  | December 31, 2004 Maturities/Repricing |         |    |             |  
|(In thousands)                                   |  | 1-3 Months                             |         |    | 4-12 Months |   |         | 13-60 Months |  |   | Over 60 Months |    |  | Total |       
|                                                 |  |                                        |         |   
|Earning Assets:                                  |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|Loans                                            |  | $                                      | 30,965  |    |             | $ | 13,411  |              |  | $ | 31,823         |    |  | $     | 48,837 |   |  | $ | 125,036 |  
|Investments                                      |  |                                        | 263     |    |             |   | 1,820   |              |  |   | 10,094         |    |  |       | 28,578 |   |  |   | 40,755  |  
|Federal funds sold                               |  |                                        | 7,175   |    |             |   |        |              |  |   |               |    |  |       |       |   |  |   | 7,175   |  
|                                                 |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|Total                                            |  | $                                      | 38,403  |    |             | $ | 15,231  |              |  | $ | 41,917         |    |  | $     | 77,415 |   |  | $ | 172,966 |  
|                                                 |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|Interest-bearing deposits:                       |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|Interest checking                                |  | $                                      | 12,799  |    |             | $ |        |              |  | $ |               |    |  | $     |       |   |  | $ | 12,799  |  
|Money market                                     |  |                                        | 3,567   |    |             |   |        |              |  |   |               |    |  |       |       |   |  |   | 3,567   |  
|Savings                                          |  |                                        | 32,439  |    |             |   | 104     |              |  |   |               |    |  |       |       |   |  |   | 32,543  |  
|Certificates of deposit                          |  |                                        | 10,228  |    |             |   | 22,581  |              |  |   | 52,326         |    |  |       |       |   |  |   | 85,135  |  
|Securities sold under agreements to repurchase   |  |                                        | 2,493   |    |             |   |        |              |  |   |               |    |  |       |       |   |  |   | 2,493   |  
|                                                 |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|Total                                            |  | $                                      | 61,526  |    |             | $ | 22,685  |              |  | $ | 52,326         |    |  | $     |       |   |  | $ | 136,537 |  
|                                                 |  |                                        |         |    |             |   |         |              |  |   |                |    |  |       |        |   |  |   |         |  
|Interest sensitivity gap                         |  | $                                      | (23,123 | )  |             | $ | (7,454  | )            |  | $ | (10,409        | )  |  | $     | 77,415 |   |  | $ | 36,429  |  
|Cumulative interest sensitivity gap              |  | $                                      | (23,123 | )  |             | $ | (30,577 | )            |  | $ | (40,986        | )  |  | $     | 36,429 |   |  | $ | 36,429  |  
|Ratio of sensitivity gap to total earning assets |  |                                        | (13.4   | )% |             |   | (4.3    | )%           |  |   | (4.9           | )% |  |       | 43.6   | % |  |   | 21.0    | %



Interest rate risk is the effect that
changes in interest rates would have on interest income and interest expense as interest-sensitive assets and interest-sensitive liabilities either reprice or mature. Management attempts to maintain the portfolios of earning assets and
interest-bearing liabilities with maturities or repricing opportunities at levels that will afford protection from erosion of net interest margin, to the extent practical, from changes in interest rates. Table 15 above shows the sensitivity of the
Companys balance sheet on December 31, 2004. This table reflects the sensitivity of the balance sheet as of that specific date and is not necessarily indicative of the position on other dates. At December 31, 2004, the Company appeared to be
liability-sensitive with interest-bearing liabilities exceeding earning assets, subject to changes in interest rates, for the first five years. Included in the interest-bearing liabilities subject to interest rate changes within three months are
interest checking accounts and savings accounts which historically have not been as interest-sensitive as other types of interest-bearing deposits. The Company appears to be asset-sensitive after the first five years.



Matching sensitive positions alone does not ensure that Cardinal has no interest rate risk.
The repricing characteristics of assets are different from the repricing characteristics of funding sources. Thus, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are
perfectly matched.



48



---

Managements Discussion and Analysis



Earnings and Balance Sheet Analysis



2003 Compared to 2002  Net interest income, on a taxable equivalent basis, was $6.4 million, lower by $380 thousand from $6.8 million in 2002. This decline
was driven primarily by the 133 basis point reduction in average yield on the Companys loan portfolio and the 146 basis point drop in average yield earned on taxable investment securities. While the rates paid on total interest-bearing
liabilities for 2003 declined 84 basis points compared to 2002, the favorable impact on net interest income brought about by the lower average rate was not sufficient to offset the decline in income from interest-earning assets. Noninterest income
grew by 8.4% to $874 thousand for 2003 compared to $806 thousand for 2002. Noninterest expense increased by 15.1% to $4.3 million compared to $3.8 million in 2002.



Earning assets averaged $178.6 million, compared to $175.5 million in 2002, the increase driven primarily by an overall increase in the
average loan portfolio of 8.2%. Real estate loan categories acccounted for the majority of the loan growth, with the construction and land development portfolio showing the largest gain. Average securities declined $2.9 million in 2003, due largely
to issuer calls of U.S. Government Agency securities and paydowns on mortgage-backed securities. Federal funds sold and deposits in other banks decreased $2.5 million and $357 thousand, respectively, on average.



Interest-bearing liabilities averaged $142.1 million, up approximately $1.0 million from
2002. While there was modest overall growth within interest-bearing liabilities, there was a noticable shift of balances within the deposits categories. Savings deposits experienced the most significant change, reflecting the decision by many
depositors to ride out the current low interest rate environment by shifting maturing time deposits and certificates of deposits into savings accounts, a trend which will begin to reverse itself once economic conditions change and interest rates
begin to rise again.



Stockholders equity grew 7.1% to an average of
$24.1 million in 2003 from $22.5 million in 2002. The return on average assets and average equity decreased to 1.07% and 8.42%, respectively for 2003 compared to 1.29% and 10.63%, respectively, for 2002. The change in both ratios reflect the adverse
effect on earnings of the two unusual matters discussed earlier. Book value per share was $15.92 at December 31, 2003, compared to $15.12 at year-end 2002, representing an increase of 5.3%.



The allowance for loan losses at December 31, 2003 was $1.7 million compared to $1.8 million
a year earlier. The allowance for loan losses as a percentage of period end loans was 1.41% compared to 1.54% at year-end 2002. The Company had charge-offs, net of recoveries, in the amount of $102 thousand for 2003. This compared to net recoveries
of $94 thousand for 2002. Nonperforming loans totaled $3.2 million at December 31, 2003, an increase of $2.4 million over 2002s level.



A Warning About Forward-Looking Statements



This annual report contains forward-looking statements. The Company may also make written forward-looking statements in periodic reports to the Securities and Exchange
Commission, proxy statements, offering circulars and prospectuses, press releases and other written materials and oral statements made by Cardinal Bankshares officers, directors or employees to third parties. Statements that are not historical
facts, including statements about the Companys beliefs and expectations, are forward-looking statements. These statements are based on beliefs and assumptions of the Companys management, and on information currently available to such
management. Forward-looking statements include statements preceded by, followed by or that include the words believes, expects, estimates, anticipates, plans, or similar expressions.
Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update publicly any of them in light of new information or future events.



49



---

Managements Discussion and Analysis



Forward-looking statements involve inherent risks and uncertainties. Management cautions the readers that a number of important factors
could cause actual results to differ materially from those contained in any forward-looking statement. Such factors include, but are not limited to, the following: competitive pressures among depository and other financial institutions may increase
significantly; changes in the interest rate environment may reduce margins; general economic or business conditions may lead to a deterioration in credit quality or a reduced demand for credit; legislative or regulatory changes, including changes in
accounting standards, may adversely affect the business in which Cardinal Bankshares is engaged; changes may occur in the securities markets; and competitors of the Company may have greater financial resources and develop products that enable such
competitors to compete more successfully than Cardinal Bankshares.



Other
factors that may cause actual results to differ from the forward-looking statements include the following: the timely development of competitive new products and services by the Company and the acceptance of such products and services by customers;
changes in consumer spending and savings habits; the effects of competitors pricing policies; the Companys success in managing the costs associated with the expansion of existing distribution channels and developing new ones, and in
realizing increased revenues from such distribution channels, including cross-selling initiatives; and mergers and acquisitions and their integration into the Company and managements ability to manage these other risks.



Management of Cardinal Bankshares believes these forward-looking statements are reasonable;
however undue reliance should not be placed on such forward-looking statements, which are based on current expectations.



Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. The future results and stockholder values of Cardinal
Bankshares may differ materially from those expressed in forward-looking statements contained in this report. Many of the factors that will determine these results and values are beyond the Companys ability to control or predict.



50