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Cardinal Bankshares Corporation and Subsidiaries

2003 Annual Report



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



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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, 2003, the Company had issued and outstanding 1,535,733 shares of common stock which were held by approximately 712 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, adjusted for a 3-for-1 stock split, effected in the form of a dividend, on April 25, 2001.



|               |  |      |       |      |   |       |  |     |       |      |   |       |  |   |       |  |   |      
|-------------- |  | ---- | ----- | ---- | - | ----- |  | --- | ----- | ---- | - | ----- |  | - | ----- |  | - | -----
|               |  | 2003 |       | 2002 |   | 2001 
|               |  | High |       | Low  |   | High  |  | Low |       | High |   | Low  
|First Quarter  |  | $    | 24.25 |      | $ | 17.60 |  | $   | 17.00 |      | $ | 14.80 |  | $ | 13.33 |  | $ | 12.00
|Second Quarter |  |      | 20.50 |      |   | 18.75 |  |     | 23.00 |      |   | 15.25 |  |   | 15.00 |  |   | 12.67
|Third Quarter  |  |      | 21.00 |      |   | 20.00 |  |     | 23.30 |      |   | 22.50 |  |   | 15.25 |  |   | 13.00
|Fourth Quarter |  |      | 21.70 |      |   | 19.75 |  |     | 23.47 |      |   | 22.35 |  |   | 16.00 |  |   | 15.00



Cash dividends paid in 2003, 2002 and
2001, were $722 thousand, $691 thousand, and $645 thousand, respectively.



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Cardinal Bankshares Corporation and Subsidiaries

Selected Historical Financial Information



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|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|-------------------------------------------------------- |  | ---- | --------- | - | ---- | - | --------- | ---- |  | - | --------- | - |  | ---- | --------- | - |  | - | --------- | -
|In thousands, except share and per share data            |  | 2003 |           |   | 2002 |   |           | 2001 |  |   | 2000      |   |  | 1999 |          
|Summary of Operations                                    |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Interest income                                          |  | $    | 9,874     |   |      | $ | 11,405    |      |  | $ | 12,572    |   |  | $    | 11,614    |   |  | $ | 10,994    |  
|Interest expense                                         |  |      | 3,809     |   |      |   | 4,965     |      |  |   | 6,474     |   |  |      | 5,982     |   |  |   | 5,603     |  
|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net interest income                                      |  |      | 6,065     |   |      |   | 6,440     |      |  |   | 6,098     |   |  |      | 5,632     |   |  |   | 5,391     |  
|Provision for loan losses                                |  |      | 30        |   |      |   | 375       |      |  |   | 442       |   |  |      | 500       |   |  |   | 142       |  
|Noninterest income                                       |  |      | 874       |   |      |   | 806       |      |  |   | 594       |   |  |      | 500       |   |  |   | 442       |  
|Noninterest expense                                      |  |      | 4,322     |   |      |   | 3,756     |      |  |   | 3,528     |   |  |      | 3,307     |   |  |   | 3,076     |  
|Income taxes                                             |  |      | 562       |   |      |   | 729       |      |  |   | 632       |   |  |      | 499       |   |  |   | 650       |  
|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Net income                                               |  | $    | 2,025     |   |      | $ | 2,386     |      |  | $ | 2,090     |   |  | $    | 1,826     |   |  | $ | 1,965     |  
|                                                         |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Per Share Data1                                          |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Basic earnings per share                                 |  | $    | 1.32      |   |      | $ | 1.55      |      |  | $ | 1.36      |   |  | $    | 1.22      |   |  | $ | 1.28      |  
|Diluted earnings per share                               |  |      | 1.32      |   |      |   | 1.55      |      |  |   | 1.36      |   |  |      | 1.22      |   |  |   | 1.28      |  
|Cash dividends declared                                  |  |      | 0.47      |   |      |   | 0.45      |      |  |   | 0.42      |   |  |      | 0.39      |   |  |   | 0.37      |  
|Book value                                               |  |      | 15.92     |   |      |   | 15.12     |      |  |   | 13.97     |   |  |      | 12.81     |   |  |   | 11.57     |  
|Year-end Balance Sheet Summary                           |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Assets                                                   |  | $    | 186,412   |   |      | $ | 189,378   |      |  | $ | 185,798   |   |  | $    | 163,240   |   |  | $ | 158,140   |  
|Loans, net                                               |  |      | 119,033   |   |      |   | 113,324   |      |  |   | 113,207   |   |  |      | 92,602    |   |  |   | 87,685    |  
|Securities                                               |  |      | 40,929    |   |      |   | 45,854    |      |  |   | 45,032    |   |  |      | 57,303    |   |  |   | 52,383    |  
|Earning assets                                           |  |      | 174,502   |   |      |   | 176,798   |      |  |   | 176,402   |   |  |      | 154,883   |   |  |   | 148,878   |  
|Deposits                                                 |  |      | 159,215   |   |      |   | 165,392   |      |  |   | 163,468   |   |  |      | 143,033   |   |  |   | 139,808   |  
|Stockholders equity                                     |  |      | 24,454    |   |      |   | 23,219    |      |  |   | 21,454    |   |  |      | 19,678    |   |  |   | 17,758    |  
|Shares outstanding                                       |  |      | 1,535,733 |   |      |   | 1,535,733 |      |  |   | 1,535,733 |   |  |      | 1,535,733 |   |  |   | 1,535,313 |  
|Average Daily Balance                                    |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Assets                                                   |  | $    | 188,831   |   |      | $ | 184,556   |      |  | $ | 173,600   |   |  | $    | 159,698   |   |  | $ | 156,627   |  
|Loans, net                                               |  |      | 116,054   |   |      |   | 107,380   |      |  |   | 105,209   |   |  |      | 88,497    |   |  |   | 84,920    |  
|Securities                                               |  |      | 43,054    |   |      |   | 45,977    |      |  |   | 49,670    |   |  |      | 56,131    |   |  |   | 47,524    |  
|Earning assets                                           |  |      | 178,553   |   |      |   | 175,466   |      |  |   | 165,302   |   |  |      | 150,780   |   |  |   | 146,021   |  
|Deposits                                                 |  |      | 162,857   |   |      |   | 161,282   |      |  |   | 151,020   |   |  |      | 139,717   |   |  |   | 137,558   |  
|Stockholders equity                                     |  |      | 24,051    |   |      |   | 22,451    |      |  |   | 20,953    |   |  |      | 18,609    |   |  |   | 17,800    |  
|Weighted average shares outstanding                      |  |      | 1,535,733 |   |      |   | 1,535,733 |      |  |   | 1,535,733 |   |  |      | 1,500,927 |   |  |   | 1,535,403 |  
|Selected Ratios                                          |  |      |           |   |      |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Return on average assets                                 |  |      | 1.07      | % |      |   | 1.29      | %    |  |   | 1.20      | % |  |      | 1.14      | % |  |   | 1.25      | %
|Return on average equity                                 |  |      | 8.42      | % |      |   | 10.60     | %    |  |   | 10.00     | % |  |      | 9.80      | % |  |   | 11.10     | %
|Dividends declared as percent of net income              |  |      | 35.65     | % |      |   | 28.96     | %    |  |   | 30.86     | % |  |      | 31.87     | % |  |   | 28.91     | %
|Net interest margin (tax-equivalent basis)               |  |      | 3.57      | % |      |   | 3.85      | %    |  |   | 3.89      | % |  |      | 3.96      | % |  |   | 3.92      | %
|Allowance for loan losses as a percentage of total loans |  |      | 1.41      | % |      |   | 1.54      | %    |  |   | 1.14      | % |  |      | 1.21      | % |  |   | 1.86      | %
|Average equity to average assets                         |  |      | 12.74     | % |      |   | 12.16     | %    |  |   | 12.07     | % |  |      | 11.65     | % |  |   | 11.36     | %
|Risk-based capital                                       |  |      | 20.37     | % |      |   | 19.80     | %    |  |   | 18.33     | % |  |      | 20.09     | % |  |   | 20.37     | %

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



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Cardinal Bankshares Corporation

Post Office Box 215

Floyd, Virginia 24091



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To Our Shareholders, Customers and Friends:



It is a pleasure to present to you our 2003 Annual Report for Cardinal Bankshares Corporation. We are pleased to report that 2003 represented another year of achievement
for Cardinal Bankshares, marked by increases in average balances for net loans, earning assets, deposits and stockholders equity, as well as important initiatives taken that will serve as a foundation for long-term earning growth.



As you review this report you will notice that our net income and net income per diluted
share for 2003 were lower than 2002, although performance was still quite good. The decline in both measurements was primarily due to two unexpected matters, one of which is nonrecurring. Both matters, in our opinion, mask the true financial results
of Cardinal Bankshares for 2003. The first source of unexpected expense was the proposed affiliation with MountainBank Financial Corporation. As you know, the shareholders did not approve the proposed transaction, so we had to expense the associated
costs. The second source of additional expense was incurred in our defense of allegations brought by our former Chief Financial Officer, who claimed we violated the Sarbanes-Oxley Act of 2002. We clearly disagree with those claims and are defending
this matter vigorously. Additional information regarding this issue is provided in the notes to consolidated financial statements. Together, these two items totaled over $400 thousand. Even with these unusual expenses, Cardinal performed well in
comparison to its peer groups. Return on assets of 1.07% compared favorably with peer group averages of 1.12%. Bank of Floyd actually performed above its peer banks in many areas.



The Board of Directors decision to increase dividends during 2003 by 4.4% to $0.47 per share marked the twelfth consecutive year of
increased dividends. This action reflects its understanding of the true core performance of Cardinal Bankshares during 2003, its acknowledgement of the capital strength of the Company, and its view of the long-term growth opportunities that exist
for your Company in the years ahead.



We are excited about the investments for
the future that we are making today. During 2003 we upgraded our mainframe system, gaining much needed processing efficiencies and capacity to absorb future growth plans for the Company. In 2004, we will install a new check imaging system and our
own backup mainframe computer. We will be opening new branches in the Christiansburg and Roanoke markets. We will aggressively look for ways to diversify our earnings in order to take advantage of opportunities that add to our bottom line and
provide additional services to our customers. We will add new members to our management team that will enable us to carry the Company forward both profitably and safely.



We look forward to 2004. The growth opportunities point to an exciting future for your Company. We approach the future with confidence
because of the dedication and hard work of our staff and the insight and direction of our Board of Directors. We appreciate their efforts. We also want to express our gratitude to you for your continued support and patronage.





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



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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, 2003 and 2002 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, 2003. 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 generally accepted in the United States of America. 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, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States of America.



/s/    Larrowe & Company, PLC

Galax, Virginia

January 9, 2004







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Cardinal Bankshares Corporation and Subsidiaries

Consolidated Balance Sheets



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|                                                                                                  |  |      |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|December 31, (In thousands)                                                                       |  | 2003 |         |   | 2002 |  
|Assets                                                                                            |  |      |         |   |      |   |         |  
|Cash and due from banks                                                                           |  | $    | 3,419   |   |      | $ | 5,175   |  
|Interest-bearing deposits in banks                                                                |  |      | 4,316   |   |      |   | 8,065   |  
|Federal funds sold                                                                                |  |      | 9,125   |   |      |   | 8,650   |  
|Investment securities available for sale, at fair value                                           |  |      | 21,771  |   |      |   | 27,963  |  
|Investment securities held to maturity                                                            |  |      | 18,560  |   |      |   | 17,027  |  
|Restricted equity securities                                                                      |  |      | 598     |   |      |   | 864     |  
|Total loans                                                                                       |  |      | 120,730 |   |      |   | 115,093 |  
|Allowance for loan losses                                                                         |  |      | (1,697  | ) |      |   | (1,769  | )
|                                                                                                  |  |      |         |   |      |   |         |  
|Net loans                                                                                         |  |      | 119,033 |   |      |   | 113,324 |  
|Bank premises and equipment, net                                                                  |  |      | 2,437   |   |      |   | 2,160   |  
|Accrued interest receivable                                                                       |  |      | 883     |   |      |   | 1,049   |  
|Foreclosed properties                                                                             |  |      | 385     |   |      |   | 671     |  
|Bank owned life insurance                                                                         |  |      | 4,327   |   |      |   | 3,149   |  
|Other assets                                                                                      |  |      | 1,558   |   |      |   | 1,281   |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total assets                                                                                      |  | $    | 186,412 |   |      | $ | 189,378 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Liabilities and Stockholders Equity                                                              |  |      |         |   |      |   |         |  
|Liabilities                                                                                       |  |      |         |   |      |   |         |  
|Noninterest-bearing deposits                                                                      |  | $    | 22,959  |   |      | $ | 21,036  |  
|Interest-bearing deposits                                                                         |  |      | 136,256 |   |      |   | 144,356 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total deposits                                                                                    |  |      | 159,215 |   |      |   | 165,392 |  
|Securities sold under agreements to repurchase                                                    |  |      | 1,826   |   |      |   |        |  
|Accrued interest payable                                                                          |  |      | 123     |   |      |   | 181     |  
|Other liabilities                                                                                 |  |      | 794     |   |      |   | 586     |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total liabilities                                                                                 |  |      | 161,958 |   |      |   | 166,159 |  
|                                                                                                  |  |      |         |   |      |   |         |  
|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                                                                                 |  |      | 5,970   |   |      |   | 4,667   |  
|Accumulated other comprehensive income                                                            |  |      | 202     |   |      |   | 270     |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total stockholders equity                                                                        |  |      | 24,454  |   |      |   | 23,219  |  
|                                                                                                  |  |      |         |   |      |   |         |  
|Total liabilities and stockholders equity                                                        |  | $    | 186,412 |   |      | $ | 189,378 |  
|                                                                                                  |  |      |         |   |      |   |         |  



See Notes to Consolidated
Financial Statements



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Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Income



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|                                                                         |  |      |           |      |   |           |  |   |          
|------------------------------------------------------------------------ |  | ---- | --------- | ---- | - | --------- |  | - | ---------
|Years ended December 31, (In thousands,
except share and per share data) |  | 2003 |           | 2002 |   | 2001     
|Interest income                                                          |  |      |           |      |   |           |  |   |          
|Loans and fees on loans                                                  |  | $    | 7,804     |      | $ | 8,670     |  | $ | 9,384    
|Federal funds sold and securities purchased under agreements to resell   |  |      | 119       |      |   | 208       |  |   | 277      
|Investment securities:                                                   |  |      |           |      |   |           |  |   |          
|Taxable                                                                  |  |      | 961       |      |   | 1,434     |  |   | 1,916    
|Exempt from federal income tax                                           |  |      | 921       |      |   | 974       |  |   | 946      
|Deposits with banks                                                      |  |      | 69        |      |   | 119       |  |   | 49       
|                                                                         |  |      |           |      |   |           |  |   |          
|Total interest income                                                    |  |      | 9,874     |      |   | 11,405    |  |   | 12,572   
|                                                                         |  |      |           |      |   |           |  |   |          
|Interest expense                                                         |  |      |           |      |   |           |  |   |          
|Deposits                                                                 |  |      | 3,781     |      |   | 4,965     |  |   | 6,471    
|Borrowings                                                               |  |      | 28        |      |   |          |  |   | 3        
|                                                                         |  |      |           |      |   |           |  |   |          
|Total interest expense                                                   |  |      | 3,809     |      |   | 4,965     |  |   | 6,474    
|                                                                         |  |      |           |      |   |           |  |   |          
|Net interest income                                                      |  |      | 6,065     |      |   | 6,440     |  |   | 6,098    
|Provision for loan losses                                                |  |      | 30        |      |   | 375       |  |   | 442      
|                                                                         |  |      |           |      |   |           |  |   |          
|Net interest income after provision for loan losses                      |  |      | 6,035     |      |   | 6,065     |  |   | 5,656    
|                                                                         |  |      |           |      |   |           |  |   |          
|Noninterest income                                                       |  |      |           |      |   |           |  |   |          
|Service charges on deposit accounts                                      |  |      | 308       |      |   | 312       |  |   | 281      
|Other service charges and fees                                           |  |      | 86        |      |   | 81        |  |   | 77       
|Net realized gains on sales of securities                                |  |      |          |      |   | 24        |  |   | 44       
|Income on bank owned life insurance                                      |  |      | 178       |      |   | 149       |  |   |         
|Other income                                                             |  |      | 302       |      |   | 240       |  |   | 192      
|                                                                         |  |      |           |      |   |           |  |   |          
|Total noninterest income                                                 |  |      | 874       |      |   | 806       |  |   | 594      
|                                                                         |  |      |           |      |   |           |  |   |          
|Noninterest expense                                                      |  |      |           |      |   |           |  |   |          
|Salaries and employee benefits                                           |  |      | 2,479     |      |   | 2,272     |  |   | 2,160    
|Occupancy and equipment                                                  |  |      | 553       |      |   | 541       |  |   | 523      
|Foreclosed assets, net                                                   |  |      | 36        |      |   | 3         |  |   | 7        
|Other operating expense                                                  |  |      | 1,254     |      |   | 940       |  |   | 838      
|                                                                         |  |      |           |      |   |           |  |   |          
|Total noninterest expense                                                |  |      | 4,322     |      |   | 3,756     |  |   | 3,528    
|                                                                         |  |      |           |      |   |           |  |   |          
|Income before income taxes                                               |  |      | 2,587     |      |   | 3,115     |  |   | 2,722    
|Income tax expense                                                       |  |      | 562       |      |   | 729       |  |   | 632      
|                                                                         |  |      |           |      |   |           |  |   |          
|Net income                                                               |  | $    | 2,025     |      | $ | 2,386     |  | $ | 2,090    
|                                                                         |  |      |           |      |   |           |  |   |          
|Basic earnings per share                                                 |  | $    | 1.32      |      | $ | 1.55      |  | $ | 1.36     
|                                                                         |  |      |           |      |   |           |  |   |          
|Diluted earnings per share                                               |  | $    | 1.32      |      | $ | 1.55      |  | $ | 1.36     
|                                                                         |  |      |           |      |   |           |  |   |          
|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



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Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Changes in Stockholders Equity



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|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   |        |  
|-------------------------------------------------------------------------------- |  | ----------- | ------ | ------------------------ | - | ---------------- |  | - | ------------------------------------------ | - |  | ----- | ---- | - |  | - | ------ | -
|(In thousands)                                                                   |  | CommonStock |        | AdditionalPaid-inCapital |   | RetainedEarnings |  |   | AccumulatedOtherComprehensiveIncome (Loss) |   |  | Total |     
|Balance, December 31, 2000                                                       |  | $           | 5,119  |                          | $ | 2,925            |  | $ | 11,765                                     |   |  | $     | (131 | ) |  | $ | 19,678 |  
|Comprehensive income                                                             |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   |        |  
|Net income                                                                       |  |             |       |                          |   |                 |  |   | 2,090                                      |   |  |       |     |   |  |   | 2,090  |  
|Net unrealized securities gains arising during the period,net of taxes of $185   |  |             |       |                          |   |                 |  |   |                                           |   |  |       | 360  |   |  |   | 360    |  
|Realized securities gains, net of taxes of $(15)                                 |  |             |       |                          |   |                 |  |   |                                           |   |  |       | (29  | ) |  |   | (29    | )
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   |        |  
|Total comprehensive income                                                       |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   | 2,421  |  
|Cash dividends declared                                                          |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   |        |  
|($0.42 per share)                                                                |  |             |       |                          |   |                 |  |   | (645                                       | ) |  |       |     |   |  |   | (645   | )
|Stock split, effected in the form of a dividend                                  |  |             | 10,238 |                          |   |                 |  |   | (10,238                                    | ) |  |       |     |   |  |   |       |  
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   |        |  
|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 |  
|                                                                                 |  |             |        |                          |   |                  |  |   |                                            |   |  |       |      |   |  |   |        |  



See Notes to Consolidated
Financial Statements



---

---

Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Cash Flows



---



|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|----------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|Years ended December 31, (In thousands)                                 |  | 2003 |         |   | 2002 |   |         | 2001 | 
|Cash flows from operating activities                                    |  |      |         |   |      |   |         |      |  |   |         |  
|Net income                                                              |  | $    | 2,025   |   |      | $ | 2,386   |      |  | $ | 2,090   |  
|Adjustments to reconcile net income to net cash provided by operations: |  |      |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                           |  |      | 245     |   |      |   | 262     |      |  |   | 250     |  
|Accretion of discount on securities, net of amortization of premiums    |  |      | 2       |   |      |   | (5      | )    |  |   | (9      | )
|Provision for loan losses                                               |  |      | 30      |   |      |   | 375     |      |  |   | 442     |  
|Deferred income taxes                                                   |  |      | (32     | ) |      |   | (171    | )    |  |   | (36     | )
|Net realized (gains) losses on securities                               |  |      |        |   |      |   | (24     | )    |  |   | (44     | )
|Deferred compensation and pension expense                               |  |      | (9      | ) |      |   | (63     | )    |  |   | 6       |  
|Changes in assets and liabilities:                                      |  |      |         |   |      |   |         |      |  |   |         |  
|Accrued income                                                          |  |      | 166     |   |      |   | 22      |      |  |   | 217     |  
|Other assets                                                            |  |      | (101    | ) |      |   | (756    | )    |  |   | 1,110   |  
|Accrued interest payable                                                |  |      | (58     | ) |      |   | (117    | )    |  |   | 25      |  
|Other liabilities                                                       |  |      | 217     |   |      |   | 71      |      |  |   | 316     |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net cash provided by operating activities                               |  |      | 2,485   |   |      |   | 1,980   |      |  |   | 4,367   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Cash flows from investing activities                                    |  |      |         |   |      |   |         |      |  |   |         |  
|Net (increase) decrease in interest-bearing deposits in banks           |  |      | 3,749   |   |      |   | (7,869  | )    |  |   | (196    | )
|Net (increase) decrease in federal funds sold                           |  |      | (475    | ) |      |   | 10,340  |      |  |   | (14,515 | )
|Purchases of investment securities                                      |  |      | (18,332 | ) |      |   | (17,255 | )    |  |   | (10,266 | )
|Sales of available for sale securities                                  |  |      |        |   |      |   | 2,020   |      |  |   | 1,000   |  
|Maturities of investment securities                                     |  |      | 22,885  |   |      |   | 14,548  |      |  |   | 22,092  |  
|Redemption of restricted equity securities                              |  |      | 265     |   |      |   |        |      |  |   |        |  
|Net increase in loans                                                   |  |      | (5,739  | ) |      |   | (492    | )    |  |   | (21,047 | )
|Net purchases of property and equipment                                 |  |      | (521    | ) |      |   | (120    | )    |  |   | (65     | )
|Investment in bank owned life insurance                                 |  |      | (1,000  | ) |      |   | (3,000  | )    |  |   |        |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net cash used by investing activities                                   |  |      | 832     |   |      |   | (1,828  | )    |  |   | (22,997 | )
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Cash flows from financing activities                                    |  |      |         |   |      |   |         |      |  |   |         |  
|Net increase in noninterest-bearing deposits                            |  |      | 1,923   |   |      |   | 929     |      |  |   | 1,761   |  
|Net increase in interest-bearing deposits                               |  |      | (8,100  | ) |      |   | 995     |      |  |   | 18,673  |  
|Net increase in other borrowings                                        |  |      | 1,826   |   |      |   |        |      |  |   |        |  
|Dividends paid                                                          |  |      | (722    | ) |      |   | (691    | )    |  |   | (645    | )
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net cash provided by financing activities                               |  |      | (5,073  | ) |      |   | 1,233   |      |  |   | 19,789  |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                    |  |      | (1,756  | ) |      |   | 1,385   |      |  |   | 1,159   |  
|Cash and cash equivalents, beginning                                    |  |      | 5,175   |   |      |   | 3,790   |      |  |   | 2,631   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents, ending                                       |  | $    | 3,419   |   |      | $ | 5,175   |      |  | $ | 3,790   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Supplemental disclosures of cash flow information                       |  |      |         |   |      |   |         |      |  |   |         |  
|Interest paid                                                           |  | $    | 3,867   |   |      | $ | 5,082   |      |  | $ | 6,449   |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  
|Income taxes paid                                                       |  | $    | 581     |   |      | $ | 806     |      |  | $ | 402     |  
|                                                                        |  |      |         |   |      |   |         |      |  |   |         |  



See Notes to Consolidated
Financial Statements



---

---

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 City of Roanoke, Virginia, through five 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.



---

---

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 and
costs on originated loans, and unamortized premiums or discounts on purchased loans.



---

---

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 capitalized 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.



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.



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 





---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



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



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 taxes 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.



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.



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



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



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.



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.



---

---

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



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.



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 $1.0 million and $980 thousand for the two week periods including December 31, 2003 and 2002, respectively.



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:



|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       
|--------------------------------- |  | ------------- | ------ | --------------- | - | ---------------- |  | --------- | --- |  | - | ------
|2003 (In thousands)               |  | AmortizedCost |        | UnrealizedGains |   | UnrealizedLosses |  | FairValue
|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
|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       





---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 3. Securities, continued



|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       
|--------------------------------- |  | ------------- | ------ | --------------- | - | ---------------- |  | --------- | --- |  | - | ------
|2002 (In thousands)               |  | AmortizedCost |        | UnrealizedGains |   | UnrealizedLosses |  | FairValue
|Available for sale                |  |               |        |                 |   |                  |  |           |     |  |   |       
|U.S. Government agency securities |  | $             | 6,785  |                 | $ | 39               |  | $         |    |  | $ | 6,824 
|State and municipal securities    |  |               | 2,629  |                 |   | 71               |  |           |    |  |   | 2,700 
|Mortgage-backed securities        |  |               | 15,641 |                 |   | 353              |  |           | 54  |  |   | 15,940
|Other securities                  |  |               | 2,499  |                 |   | 67               |  |           | 67  |  |   | 2,499 
|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       
|                                  |  | $             | 27,554 |                 | $ | 530              |  | $         | 121 |  | $ | 27,963
|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       
|Held to maturity                  |  |               |        |                 |   |                  |  |           |     |  |   |       
|State and municipal securities    |  | $             | 17,017 |                 | $ | 1,017            |  | $         |    |  | $ | 18,034
|Mortgage-backed securities        |  |               | 10     |                 |   |                 |  |           |    |  |   | 10    
|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       
|                                  |  | $             | 17,027 |                 | $ | 1,017            |  | $         |    |  | $ | 18,044
|                                  |  |               |        |                 |   |                  |  |           |     |  |   |       



Restricted equity securities 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 $10.5 million and
$11.2 million at December 31, 2003 and 2002, 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)                                 |  | 2003 |   | 2002 |   | 2001
|Realized gains, available for sale securities  |  | $    |  |      | $ | 24   |  | $ | 44
|Realized losses, available for sale securities |  |      |  |      |   |     |  |   |  
|                                               |  |      |   |      |   |      |  |   |   
|                                               |  | $    |  |      | $ | 24   |  | $ | 44
|                                               |  |      |   |      |   |      |  |   |   



The scheduled maturities of debt
securities available for sale and held to maturity at December 31, 2003, were as follows:



|                                       |  |                    |        |                  |   |                |  |            |        |  |   |       
|-------------------------------------- |  | ------------------ | ------ | ---------------- | - | -------------- |  | ---------- | ------ |  | - | ------
|(In thousands)                         |  | Available for Sale |        | Held to Maturity
|                                       |  | Amortized Cost     |        | Fair Value       |   | Amortized Cost |  | Fair Value
|Due in one year or less                |  | $                  | 29     |                  | $ | 30             |  | $          | 665    |  | $ | 667   
|Due after one year through five years  |  |                    | 4,351  |                  |   | 4,392          |  |            | 5,170  |  |   | 5,466 
|Due after five years through ten years |  |                    | 2,308  |                  |   | 2,378          |  |            | 6,932  |  |   | 7,452 
|Due after ten years                    |  |                    | 14,777 |                  |   | 14,971         |  |            | 5,793  |  |   | 5,979 
|                                       |  |                    |        |                  |   |                |  |            |        |  |   |       
|                                       |  | $                  | 21,465 |                  | $ | 21,771         |  | $          | 18,560 |  | $ | 19,564
|                                       |  |                    |        |                  |   |                |  |            |        |  |   |       



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



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 3. Securities, continued



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, 2003.



|                                      |  |                     |       |                   |   |           |  |                  |       |           |   |                  |  |   |        |  |   |    
|------------------------------------- |  | ------------------- | ----- | ----------------- | - | --------- |  | ---------------- | ----- | --------- | - | ---------------- |  | - | ------ |  | - | ---
|                                      |  | Less Than 12 Months |       | 12 Months or More |   | Total    
|                                      |  | FairValue           |       | UnrealizedLosses  |   | FairValue |  | UnrealizedLosses |       | FairValue |   | UnrealizedLosses
|State and municipal securities        |  | $                   | 1,185 |                   | $ | 16        |  | $                |      |           | $ |                 |  | $ | 1,185  |  | $ | 16 
|Mortgage - backed securities          |  |                     | 5,946 |                   |   | 92        |  |                  | 3,081 |           |   | 42               |  |   | 9,027  |  |   | 134
|                                      |  |                     |       |                   |   |           |  |                  |       |           |   |                  |  |   |        |  |   |    
|Total temporarily impaired securities |  | $                   | 7,131 |                   | $ | 108       |  | $                | 3,081 |           | $ | 42               |  | $ | 10,212 |  | $ | 150
|                                      |  |                     |       |                   |   |           |  |                  |       |           |   |                  |  |   |        |  |   |    



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.



Note 4. Loans Receivable



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



|                                                       |  |      |         |   |      |   |         |  
|------------------------------------------------------ |  | ---- | ------- | - | ---- | - | ------- | -
|December 31, (In thousands)                            |  | 2003 |         |   | 2002 |  
|Commercial                                             |  | $    | 6,163   |   |      | $ | 6,773   |  
|Real estate                                            |  |      |         |   |      |   |         |  
|Construction and land development                      |  |      | 7,212   |   |      |   | 2,188   |  
|Residential, 1-4 families                              |  |      | 30,293  |   |      |   | 29,811  |  
|Residential, 5 or more families                        |  |      | 4,880   |   |      |   | 3,238   |  
|Farmland                                               |  |      | 3,303   |   |      |   | 3,148   |  
|Nonfarm, nonresidential                                |  |      | 65,732  |   |      |   | 65,892  |  
|Agricultural                                           |  |      | 813     |   |      |   | 1,082   |  
|Consumer                                               |  |      | 2,568   |   |      |   | 3,069   |  
|Other                                                  |  |      | 93      |   |      |   | 230     |  
|                                                       |  |      |         |   |      |   |         |  
|Gross loans                                            |  |      | 121,057 |   |      |   | 115,431 |  
|Unearned discount and net deferred loan fees and costs |  |      | (327    | ) |      |   | (338    | )
|                                                       |  |      |         |   |      |   |         |  
|Total loans                                            |  |      | 120,730 |   |      |   | 115,093 |  
|Allowance for loan losses                              |  |      | (1,697  | ) |      |   | (1,769  | )
|                                                       |  |      |         |   |      |   |         |  
|Net loans                                              |  | $    | 119,033 |   |      | $ | 113,324 |  
|                                                       |  |      |         |   |      |   |         |  



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 5. Allowance for Loan Losses



Changes in the allowance for loan losses are as follows:



|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|-------------------------------------------------------------------------------------- |  | ---- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|Years ended December 31, (In thousands)                                                |  | 2003 |       |   | 2002 |   |       | 2001 | 
|Balance, at January 1                                                                  |  | $    | 1,769 |   |      | $ | 1,300 |      |  | $ | 1,134 |  
|Provision charged to expense                                                           |  |      | 30    |   |      |   | 375   |      |  |   | 442   |  
|Recoveries of amounts charged off                                                      |  |      | 30    |   |      |   | 190   |      |  |   | 208   |  
|Amounts charged off                                                                    |  |      | (132  | ) |      |   | (96   | )    |  |   | (484  | )
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|Balance, at December 31                                                                |  | $    | 1,697 |   |      | $ | 1,769 |      |  | $ | 1,300 |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|The following is a summary of information pertaining to
impaired loans at December 31: | 
|(In thousands)                                                                         |  |      |       |   | 2003 |   |       | 2002 | 
|Impaired loans without a valuation allowance                                           |  |      |       |   |      | $ |      |      |  | $ |      |  
|Impaired loans with a valuation allowance                                              |  |      |       |   |      |   | 2,816 |      |  |   | 144   |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|Total impaired loans                                                                   |  |      |       |   |      | $ | 2,816 |      |  | $ | 144   |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|Valuation allowance related to impaired loans                                          |  |      |       |   |      | $ | 84    |      |  | $ | 72    |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|                                                                                       |  |      |      
|                                                                                       |  | 2003 |       |   | 2002 |   |       | 2001 | 
|Average investment in impaired loans                                                   |  | $    | 1,458 |   |      | $ | 18    |      |  | $ | 631   |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|Interest income recognized for the year                                                |  | $    | 67    |   |      | $ | 11    |      |  | $ | 57    |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  
|Interest income recognized on a cash basis for the year                                |  | $    | 40    |   |      | $ | 9     |      |  | $ | 35    |  
|                                                                                       |  |      |       |   |      |   |       |      |  |   |       |  



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, 2003, were $2.8 million and $15 thousand, respectively. At December 31, 2002, those amounts were $0 and $100 thousand, respectively.



---

---

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)      |  | 2003 |        |   | 2002 |  
|Land                             |  | $    | 704    |   |      | $ | 378    |  
|Bank premises                    |  |      | 2,686  |   |      |   | 2,684  |  
|Furniture and equipment          |  |      | 2,321  |   |      |   | 2,147  |  
|                                 |  |      |        |   |      |   |        |  
|Total                            |  |      | 5,711  |   |      |   | 5,209  |  
|Less accumulated depreciation    |  |      | (3,274 | ) |      |   | (3,049 | )
|                                 |  |      |        |   |      |   |        |  
|Bank premises and equipment, net |  | $    | 2,437  |   |      | $ | 2,160  |  
|                                 |  |      |        |   |      |   |        |  



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 2005 and 2006, including the exercise of renewal options ranging from one to two years. Future minimum lease payments
total $9 thousand annually. Rental expense was $9 thousand per year for 2003, 2002 and 2001.



Note 7. Maturities of Certificates



The
aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2003 and 2002 was $17.1 million and $23.2 million, respectively. At December 31, 2003, the scheduled maturities of time deposits are as follows:



|      |  |                |       
|----- |  | -------------- | ------
|      |  | (In thousands)
|2004  |  | $              | 41,493
|2005  |  |                | 14,431
|2006  |  |                | 7,062 
|2007  |  |                | 8,295 
|2008  |  |                | 12,884
|      |  |                |       
|Total |  | $              | 84,165
|      |  |                |       



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:



|                                                       |  |      |       |   |      |   |   |  
|------------------------------------------------------ |  | ---- | ----- | - | ---- | - | - | -
|                                                       |  | 2003 |       |   | 2002 |  
|Outstanding balance at December 31                     |  | $    | 1,286 |   |      | $ |  |  
|                                                       |  |      |       |   |      |   |   |  
|Year-end weighted average rate                         |  |      | 2.10  | % |      |   |  | %
|                                                       |  |      |       |   |      |   |   |  
|Daily average outstanding during the period            |  | $    | 1,263 |   |      | $ |  |  
|                                                       |  |      |       |   |      |   |   |  
|Average rate for the year                              |  |      | 2.22  | % |      |   |  | %
|                                                       |  |      |       |   |      |   |   |  
|Maximum outstanding at any month-end during the period |  | $    | 2,849 |   |      | $ |  |  
|                                                       |  |      |       |   |      |   |   |  



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 $10.3 million and a secured line of credit with the Federal Home Loan Bank of Atlanta of approximately $22
million. Additional amounts are available from the Federal Home Loan Bank, with additional collateral. At December 31, 2003 and 2002, there were no amounts outstanding under these agreements.



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



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)                    |  |      |      |   | 2003 |   |       | 2002 | 
|Change in benefit obligation                   |  |      |      |   |      |   |       |      |  |   |       |  
|Benefit obligation at beginning of year        |  |      |      |   |      | $ | 2,115 |      |  | $ | 1,665 |  
|Service cost                                   |  |      |      |   |      |   | 137   |      |  |   | 113   |  
|Interest cost                                  |  |      |      |   |      |   | 148   |      |  |   | 124   |  
|Actuarial (gain) loss                          |  |      |      |   |      |   | 166   |      |  |   | 254   |  
|Benefits paid                                  |  |      |      |   |      |   | (49   | )    |  |   | (41   | )
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Benefit obligation at end of year              |  |      |      |   |      | $ | 2,517 |      |  | $ | 2,115 |  
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Change in plan assets                          |  |      |      |   |      |   |       |      |  |   |       |  
|Fair value of plan assets at beginning of year |  |      |      |   |      | $ | 1,464 |      |  | $ | 1,466 |  
|Actual return on plan assets                   |  |      |      |   |      |   | 256   |      |  |   | (103  | )
|Employer contribution                          |  |      |      |   |      |   | 177   |      |  |   | 142   |  
|Benefits paid                                  |  |      |      |   |      |   | (49   | )    |  |   | (41   | )
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Fair value of plan assets at end of year       |  |      |      |   |      | $ | 1,848 |      |  | $ | 1,464 |  
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Change in prepaid (accrued) benefit cost       |  |      |      |   |      |   |       |      |  |   |       |  
|Prepaid (accrued) benefit cost, beginning      |  |      |      |   |      | $ | (121  | )    |  | $ | (151  | )
|Contributions                                  |  |      |      |   |      |   | 177   |      |  |   | 142   |  
|Pension cost                                   |  |      |      |   |      |   | (177  | )    |  |   | (112  | )
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Prepaid (accrued) benefit cost, ending         |  |      |      |   |      | $ | (121  | )    |  | $ | (121  | )
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Funded status                                  |  |      |      |   |      | $ | (669  | )    |  | $ | (651  | )
|Unrecognized transitional net assets           |  |      |      |   |      |   | (24   | )    |  |   | (28   | )
|Unrecognized prior service cost                |  |      |      |   |      |   | 48    |      |  |   | 54    |  
|Unrecognized net actuarial (gain) loss         |  |      |      |   |      |   | 524   |      |  |   | 504   |  
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Prepaid (accrued) benefit cost                 |  |      |      |   |      | $ | (121  | )    |  | $ | (121  | )
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Weighted-average assumptions as of December 31 |  |      |      |   |      |   |       |      |  |   |       |  
|Discount rate                                  |  |      |      |   |      |   | 6.5   | %    |  |   | 7.0   | %
|Expected return on plan assets                 |  |      |      |   |      |   | 8.5   | %    |  |   | 9.0   | %
|Rate of compensation increase                  |  |      |      |   |      |   | 5.0   | %    |  |   | 5.0   | %
|                                               |  |      |     
|                                               |  | 2003 |      |   | 2002 |   |       | 2001 | 
|Components of net periodic benefit cost        |  |      |      |   |      |   |       |      |  |   |       |  
|Service cost                                   |  | $    | 137  |   |      | $ | 113   |      |  | $ | 117   |  
|Interest cost                                  |  |      | 148  |   |      |   | 124   |      |  |   | 115   |  
|Return on plan assets                          |  |      | (256 | ) |      |   | 103   |      |  |   | 223   |  
|Originating unrecognized asset gain (loss)     |  |      | 131  |   |      |   | (230  | )    |  |   | (360  | )
|Amortization                                   |  |      | 2    |   |      |   | 2     |      |  |   | 2     |  
|Recognized net actuarial (gain) loss           |  |      | 15   |   |      |   |      |      |  |   | (5    | )
|                                               |  |      |      |   |      |   |       |      |  |   |       |  
|Net periodic benefit cost                      |  | $    | 177  |   |      | $ | 112   |      |  | $ | 92    |  
|                                               |  |      |      |   |      |   |       |      |  |   |       |  



The accumulated benefit obligation for
the defined benefit pension plan was $1.6 million and $1.3 million at December 31, 2003 and 2002.



Contributions are expected to be approximately $199 thousand in 2004.



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 9. Employee Benefit Plan, continued



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:



|                            |  |      |   |  |      |  
|--------------------------- |  | ---- | - |  | ---- | -
|                            |  | 2003 |   |  | 2002 |  
|Mutual funds  fixed income |  | 40   | % |  | 40   | %
|Mutual funds  equity       |  | 60   | % |  | 60   | %
|                            |  |      |   |  |      |  
|Total                       |  | 100  | % |  | 100  | %
|                            |  |      |   |  |      |  



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 $101 thousand and $110 thousand at December 31, 2003 and 2002, respectively.



Charges to income are based on present value of future cash payments, discounted at 8%, and amounted to $17 thousand, $14 thousand and $12
thousand for 2003, 2002 and 2001, respectively.



The Bank is owner and
beneficiary of life insurance policies on these directors. Policy cash values, net of policy loans, totaled $87 thousand and $72 thousand at December 31, 2003 and 2002, 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 $165 thousand and $76
thousand at December 31, 2003 and 2002, respectively.



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 11. Fair Value of Financial Instruments



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



|                                               |  |                |         |            |   |                |  |            |         |  |   |        
|---------------------------------------------- |  | -------------- | ------- | ---------- | - | -------------- |  | ---------- | ------- |  | - | -------
|December 31, (In thousands)                    |  | 2003           |         | 2002      
|                                               |  | CarryingAmount |         | Fair Value |   | CarryingAmount |  | Fair Value
|Financial assets                               |  |                |         |            |   |                |  |            |         |  |   |        
|Cash and due from banks                        |  | $              | 3,419   |            | $ | 3,419          |  | $          | 5,175   |  | $ | 5,175  
|Interest-bearing deposits with banks           |  |                | 4,316   |            |   | 4,316          |  |            | 8,065   |  |   | 8,065  
|Federal funds sold                             |  |                | 9,125   |            |   | 9,125          |  |            | 8,650   |  |   | 8,650  
|Securities, available-for-sale                 |  |                | 21,771  |            |   | 21,771         |  |            | 27,963  |  |   | 27,963 
|Securities, held to maturity                   |  |                | 18,560  |            |   | 19,590         |  |            | 17,027  |  |   | 18,044 
|Restricted equity securities                   |  |                | 598     |            |   | 598            |  |            | 864     |  |   | 864    
|Total loans                                    |  |                | 120,730 |            |   | 121,795        |  |            | 113,324 |  |   | 116,128
|Financial liabilities                          |  |                |         |            |   |                |  |            |         |  |   |        
|Deposits                                       |  |                | 159,215 |            |   | 162,421        |  |            | 165,392 |  |   | 171,822
|Securities sold under agreements to repurchase |  |                | 1,826   |            |   | 1,826          |  |            |        |  |   |       



Note 12. Income Taxes



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



|                                        |  |      |     |      |   |      |      |  |   |     |  
|--------------------------------------- |  | ---- | --- | ---- | - | ---- | ---- |  | - | --- | -
|Years ended December 31, (In thousands) |  | 2003 |     | 2002 |   |      | 2001 | 
|Current taxes  federal                 |  | $    | 530 |      | $ | 900  |      |  | $ | 668 |  
|Deferred taxes  federal                |  |      | 32  |      |   | (171 | )    |  |   | (36 | )
|                                        |  |      |     |      |   |      |      |  |   |     |  
|Income tax expense                      |  | $    | 562 |      | $ | 729  |      |  | $ | 632 |  
|                                        |  |      |     |      |   |      |      |  |   |     |  



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) |  | 2003 |      |   | 2002 |   |       | 2001 | 
|Expected tax expense                    |  | $    | 879  |   |      | $ | 1,059 |      |  | $ | 926  |  
|Tax exempt interest                     |  |      | (314 | ) |      |   | (334  | )    |  |   | (334 | )
|Other                                   |  |      | (3   | ) |      |   | 4     |      |  |   | 40   |  
|                                        |  |      |      |   |      |   |       |      |  |   |      |  
|Income tax expense                      |  | $    | 562  |   |      | $ | 729   |      |  | $ | 632  |  
|                                        |  |      |      |   |      |   |       |      |  |   |      |  



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)                                  |  | 2003 |      |   | 2002 |  
|Deferred tax assets                                          |  |      |      |   |      |   |      |  
|Allowance for loan and other real estate losses              |  | $    | 446  |   |      | $ | 436  |  
|Deferred loan interest, fees                                 |  |      | 111  |   |      |   | 143  |  
|Employee benefit liabilities                                 |  |      | 161  |   |      |   | 123  |  
|Other valuation reserves                                     |  |      | 51   |   |      |   | 60   |  
|                                                             |  |      |      |   |      |   |      |  
|Total deferred tax assets                                    |  |      | 769  |   |      |   | 762  |  
|                                                             |  |      |      |   |      |   |      |  
|Deferred tax liabilities                                     |  |      |      |   |      |   |      |  
|Net unrealized appreciation on securities available for sale |  |      | (104 | ) |      |   | (139 | )
|Depreciation                                                 |  |      | (116 | ) |      |   | (79  | )
|Accretion of discount on investment securities               |  |      | (36  | ) |      |   | (34  | )
|                                                             |  |      |      |   |      |   |      |  
|Total deferred tax liabilities                               |  |      | (256 | ) |      |   | (252 | )
|                                                             |  |      |      |   |      |   |      |  
|Net deferred tax asset                                       |  | $    | 513  |   |      | $ | 510  |  
|                                                             |  |      |      |   |      |   |      |  



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



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. The matter is presently before the Administrative Review Board. Cardinal intends to pursue its appeal
rights vigorously and believes that the Administrative Law Judges decision is erroneous, factually and legally. However, should the Administrative Law Judges decision be upheld, Cardinal estimates the damages recoverable by the plaintiff
would not exceed $150,000.



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)  |  | 2003 |       | 2002
|Commitments to extend credit |  | $    | 3,588 |      | $ | 7,537
|Standby letters of credit    |  |      | 710   |      |   | 659  
|                             |  |      |       |      |   |      
|                             |  | $    | 4,298 |      | $ | 8,196
|                             |  |      |       |      |   |      



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.



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 13. Commitments and Contingencies, continued



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.



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 City of Roanoke, Virginia. A significant amount of the real estate loans set forth in the Loans Receivable note are secured by
commercial real estate. In addition, the Company has a loan concentration relating to customers who are motel, hotel, and bed-and-breakfast owners and operators. Total loans and loan commitments to this industrial group amounted to approximately
$16.8 million and $17.7 million at December 31, 2003 and 2002, respectively.



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 $1.6 million at December 31, 2003. No 23A transactions were deemed to exist between the Company and the Bank at December 31, 2003.



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.



---

---

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements



---



Note 14. Regulatory Matters, continued



Capital Requirements, continued



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, 2003 and 2002, that the
Company and the Bank met all capital adequacy requirements to which they are subject.



As of December 31, 2003, 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 |        |       | MinimumFor CapitalAdequacy Purposes |   |        | Minimum To Be WellCapitalized UnderPrompt CorrectiveAction Provisions |       
|In thousands                          |  | Amount |        | Ratio |                                     |   | Amount |                                                                       | Ratio  |  |      | Amount |  | Ratio |       
|December 31, 2003                     |  |        |        |       |                                     |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Total capitalto 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 capitalto 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 capitalto 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  | %
|December 31, 2002                     |  |        |        |       |                                     |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Total capitalto risk-weighted assets  |  |        |        |       |                                     |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                          |  | $      | 24,499 |       | 19.80                               | % |        | $                                                                     | 9,900  |  | 8.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                         |  |        | 15,631 |       | 12.99                               | % |        |                                                                       | 9,628  |  | 8.00 | %      |  | $     | 12,035 |  | 10.00 | %
|Tier I capitalto risk-weighted assets |  |        |        |       |                                     |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                          |  |        | 22,949 |       | 18.54                               | % |        |                                                                       | 4,950  |  | 4.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                         |  |        | 14,124 |       | 11.74                               | % |        |                                                                       | 4,814  |  | 4.00 | %      |  |       | 7,221  |  | 6.00  | %
|Tier I capitalto average assets       |  |        |        |       |                                     |   |        |                                                                       |        |  |      |        |  |       |        |  |       |  
|Consolidated                          |  |        | 22,949 |       | 12.37                               | % |        |                                                                       | 7,424  |  | 4.00 | %      |  |       | n/a    |  | n/a   |  
|Bank of Floyd                         |  |        | 14,124 |       | 7.77                                | % |        |                                                                       | 7,275  |  | 4.00 | %      |  |       | 9,093  |  | 5.00  | %





---

---

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) |  | 2003 |       |   | 2002 |  
|Balance, beginning          |  | $    | 1,177 |   |      | $ | 874   |  
|Additions                   |  |      | 217   |   |      |   | 340   |  
|Repayments                  |  |      | (233  | ) |      |   | (190  | )
|Relationship changes        |  |      |      |   |      |   | 153   |  
|                            |  |      |       |   |      |   |       |  
|Balance, ending             |  | $    | 1,161 |   |      | $ | 1,177 |  
|                            |  |      |       |   |      |   |       |  



Note 16. Parent Company Financial
Information



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



Balance Sheets



|                                                        |  |      |        |   |      |   |        |  
|------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|December 31, (In thousands)                             |  | 2003 |        |   | 2002 |  
|Assets                                                  |  |      |        |   |      |   |        |  
|Cash due from banks                                     |  | $    | 2,371  |   |      | $ | 4,229  |  
|Investment securities available for sale, at fair value |  |      | 782    |   |      |   | 673    |  
|Total loans                                             |  |      | 4,455  |   |      |   | 2,535  |  
|Allowance for loan losses                               |  |      | (25    | ) |      |   | (25    | )
|                                                        |  |      |        |   |      |   |        |  
|Net loans                                               |  |      | 4,430  |   |      |   | 2,510  |  
|                                                        |  |      |        |   |      |   |        |  
|Investment in affiliate bank at equity                  |  |      | 15,930 |   |      |   | 14,435 |  
|Other assets                                            |  |      | 942    |   |      |   | 1,374  |  
|                                                        |  |      |        |   |      |   |        |  
|Total assets                                            |  | $    | 24,455 |   |      | $ | 23,221 |  
|                                                        |  |      |        |   |      |   |        |  
|Liabilities                                             |  |      |        |   |      |   |        |  
|Other liabilities                                       |  | $    | 1      |   |      | $ | 2      |  
|                                                        |  |      |        |   |      |   |        |  
|Total liabilities                                       |  |      | 1      |   |      |   | 2      |  
|                                                        |  |      |        |   |      |   |        |  
|Stockholders equity                                    |  |      |        |   |      |   |        |  
|Common stock                                            |  |      | 15,357 |   |      |   | 15,357 |  
|Additional paid-in capital                              |  |      | 2,925  |   |      |   | 2,925  |  
|Retained earnings                                       |  |      | 5,970  |   |      |   | 4,667  |  
|Accumulated other comprehensive income                  |  |      | 202    |   |      |   | 270    |  
|                                                        |  |      |        |   |      |   |        |  
|Total stockholders equity                              |  |      | 24,454 |   |      |   | 23,219 |  
|                                                        |  |      |        |   |      |   |        |  
|Total liabilities and stockholders equity              |  | $    | 24,455 |   |      | $ | 23,221 |  
|                                                        |  |      |        |   |      |   |        |  





---

---

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)                                                 |  | 2003 |       | 2002 |   | 2001  | 
|Income                                                                                  |  |      |       |      |   |       |  |   |        |  
|Dividends from affiliate bank                                                           |  | $    | 722   |      | $ | 755   |  | $ | 3,500  |  
|Interest on loans                                                                       |  |      | 210   |      |   | 225   |  |   | 211    |  
|Interest on investment securities                                                       |  |      | 61    |      |   | 54    |  |   |       |  
|                                                                                        |  |      |       |      |   |       |  |   |        |  
|Total income                                                                            |  |      | 993   |      |   | 1,034 |  |   | 3,711  |  
|                                                                                        |  |      |       |      |   |       |  |   |        |  
|Expenses                                                                                |  |      |       |      |   |       |  |   |        |  
|Management and professional fees                                                        |  |      | 684   |      |   | 280   |  |   | 251    |  
|Other expenses                                                                          |  |      | 94    |      |   | 38    |  |   | 45     |  
|                                                                                        |  |      |       |      |   |       |  |   |        |  
|Total expenses                                                                          |  |      | 778   |      |   | 318   |  |   | 296    |  
|                                                                                        |  |      |       |      |   |       |  |   |        |  
|Income before income tax benefit and equity in undistributed net income of subsidiaries |  |      | 215   |      |   | 716   |  |   | 3,415  |  
|Income tax benefit                                                                      |  |      | 175   |      |   | 5     |  |   | 29     |  
|                                                                                        |  |      |       |      |   |       |  |   |        |  
|Income before equity in undistributed net income of subsidiaries                        |  |      | 390   |      |   | 721   |  |   | 3,444  |  
|Equity in undistributed net income of subsidiaries                                      |  |      | 1,635 |      |   | 1,665 |  |   | (1,354 | )
|                                                                                        |  |      |       |      |   |       |  |   |        |  
|Net income                                                                              |  | $    | 2,025 |      | $ | 2,386 |  | $ | 2,090  |  
|                                                                                        |  |      |       |      |   |       |  |   |        |  



Statements of
Cash Flows



|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|--------------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|Years ended December 31, (In thousands)                                           |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Cash flows from operating activities                                              |  |      |        |   |      |   |        |      |  |   |        |  
|Net income                                                                        |  | $    | 2,025  |   |      | $ | 2,386  |      |  | $ | 2,090  |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |      |        |   |      |   |        |      |  |   |        |  
|Amortization                                                                      |  |      |       |   |      |   |       |      |  |   | 3      |  
|Equity in undistributed income of subsidiaries                                    |  |      | (1,635 | ) |      |   | (1,665 | )    |  |   | 1,354  |  
|Net change in other assets                                                        |  |      | 395    |   |      |   | (1,286 | )    |  |   | 762    |  
|Net change in other liabilities                                                   |  |      | (1     | ) |      |   | (22    | )    |  |   | 24     |  
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Net cash provided (used) by operating activities                                  |  |      | 784    |   |      |   | (587   | )    |  |   | 4,233  |  
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Cash flows from investing activities                                              |  |      |        |   |      |   |        |      |  |   |        |  
|Net (increase) decrease in loans                                                  |  |      | (1,920 | ) |      |   | 560    |      |  |   | (1,050 | )
|Purchases of investment securities                                                |  |      |       |   |      |   | (750   | )    |  |   |       |  
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Net cash provided (used) by investing activities                                  |  |      | (1,920 | ) |      |   | (190   | )    |  |   | (1,050 | )
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Cash flows from financing activities                                              |  |      |        |   |      |   |        |      |  |   |        |  
|Dividends paid                                                                    |  |      | (722   | ) |      |   | (691   | )    |  |   | (645   | )
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Net cash used by financing activities                                             |  |      | (722   | ) |      |   | (691   | )    |  |   | (645   | )
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Net increase (decrease) in cash and cash equivalents                              |  |      | (1,858 | ) |      |   | (1,468 | )    |  |   | 2,538  |  
|Cash and cash equivalents, beginning                                              |  |      | 4,229  |   |      |   | 5,697  |      |  |   | 3,159  |  
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  
|Cash and cash equivalents, ending                                                 |  | $    | 2,371  |   |      | $ | 4,229  |      |  | $ | 5,697  |  
|                                                                                  |  |      |        |   |      |   |        |      |  |   |        |  





---

---

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 five
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 office is in the Cave Spring area of Roanoke County. 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 government leaders in an effort to attract industry to Floyd County.



Cardinal Bankshares reported net income for the year 2003 of $2.0 million compared to $2.4 million reported in 2002. Net income per diluted share was $1.32, $.23 lower
than the $1.55 reported for the prior year. The decline in net income was primarily attributable to two events which are considered to be uncharacteristic of the Companys normal results of operation. The first is the Companys recognition
during the year of approximately $258 thousand, or $170 thousand net of taxes, in expenses related to the proposed merger with MountainBank Financial Corporation. On February 26, 2003, the Registrants shareholders failed to ratify and approve
the proposed merger.



The second event relates to expenses incurred defending a
complaint filed with the U.S. Department of Labor (DOL) by a former employee in December 2002 claiming that his discharge violated the Sarbanes-Oxley Act of 2002. The complaint was initially reviewed by the DOL finding that the employee
was not dismissed for protected activity but for legitimate business reasons. The former employee appealed the decision and under DOL procedures, the appeal automatically resulted in a trial of the former employees allegations before a DOL
Administrative Law Judge. In January 2004, the Administrative Law Judge reversed the earlier decision in Cardinals favor and entered a decision in favor of the former employee. Cardinal has appealed that decision. The Administrative Review
Board of the DOL agreed to review the decision of the Administrative Law Judge in February 2004. The matter is presently before the Administrative Review Board. Cardinal intends to vigorously pursue its appeal rights and believes that the
Administrative Law Judges decision is erroneous, factually and legally. Expenses incurred during 2003 related to this matter, principally legal, totaled approximately $154 thousand, or $102 thousand net of taxes. The combined cost of these two
events totaled approximately $412 thousand, or $272 thousand net of taxes.



Excluding the effect of the proposed merger expenses and the costs associated with the employee matter; Cardinal Bankshares would have reported net income of $2.3 million, or $1.50 per diluted share for 2003.



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 deposits 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, mainly due to the unusal expense related
to the two items discussed above.



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 8.1%. 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



1



---

---



Managements Discussion and Analysis



---



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 10.60%, 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%.



2



---

---



Managements Discussion and Analysis



---



---



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



---



|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|----------------------------------------------- |  | -------------- | ------- | - | ----------------------- | - | ---------- | ---- | ---- | -------------- |  | - | ---------------------- | - | ---------- | - | ------ | -------------- | ---- | - | ----------------------- | - | ---------- | - |  | - | ------ |  | ---- | -
|Years ended December 31, (In thousands)         |  | 2003           |         |   | 2002                    |   |            | 2001 |     
|                                                |  | AverageBalance |         |   | Interest Income/Expense |   | Yield/Cost |      |      | AverageBalance |  |   | InterestIncome/Expense |   | Yield/Cost |   |        | AverageBalance |      |   | Interest Income/Expense |   | Yield/Cost |  
|Assets:                                         |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Interest-earning assets:                        |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Deposits in other banks                         |  | $              | 6,350   |   |                         | $ | 69         |      | 1.08 | %              |  | $ | 6,707                  |   |            | $ | 119    |                | 1.77 | % |                         | $ | 1,620      |   |  | $ | 49     |  | 3.02 | %
|Taxable investment securities                   |  |                | 23,549  |   |                         |   | 961        |      | 4.08 | %              |  |   | 25,880                 |   |            |   | 1,433  |                | 5.54 | % |                         |   | 29,669     |   |  |   | 1,916  |  | 6.46 | %
|Nontaxable investment securities                |  |                | 19,505  |   |                         |   | 1,234      |      | 6.32 | %              |  |   | 20,097                 |   |            |   | 1,293  |                | 6.43 | % |                         |   | 20,001     |   |  |   | 1,268  |  | 6.34 | %
|Federal funds sold                              |  |                | 11,354  |   |                         |   | 119        |      | 1.05 | %              |  |   | 13,884                 |   |            |   | 208    |                | 1.50 | % |                         |   | 7,644      |   |  |   | 277    |  | 3.62 | %
|Loans                                           |  |                | 117,795 |   |                         |   | 7,806      |      | 6.63 | %              |  |   | 108,898                |   |            |   | 8,672  |                | 7.96 | % |                         |   | 106,368    |   |  |   | 9,395  |  | 8.83 | %
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Total interest-earning assets                   |  |                | 178,553 |   |                         |   | 10,189     |      | 5.71 | %              |  |   | 175,466                |   |            |   | 11,725 |                | 6.68 | % |                         |   | 165,302    |   |  |   | 12,905 |  | 7.81 | %
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Noninterest-earning assets:                     |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Cash and due from banks                         |  |                | 3,350   |   |                         |   |            |      |      |                |  |   | 3,027                  |   |            |   |        |                |      |   |                         |   | 3,567      |   |  |   |        |  |      |  
|Premises and equipment                          |  |                | 2,172   |   |                         |   |            |      |      |                |  |   | 2,263                  |   |            |   |        |                |      |   |                         |   | 2,534      |   |  |   |        |  |      |  
|Other assets                                    |  |                | 6,497   |   |                         |   |            |      |      |                |  |   | 5,318                  |   |            |   |        |                |      |   |                         |   | 3,356      |   |  |   |        |  |      |  
|Allowance for loan losses                       |  |                | (1,741  | ) |                         |   |            |      |      |                |  |   | (1,518                 | ) |            |   |        |                |      |   |                         |   | (1,159     | ) |  |   |        |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Total assets                                    |  | $              | 188,831 |   |                         |   |            |      |      |                |  | $ | 184,556                |   |            |   |        |                |      |   |                         | $ | 173,600    |   |  |   |        |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|                                                |  |                |         |   |                         |   |            |      |     
|Liabilities and stockholders equity:           |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Interest-bearing liabilities:                   |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Interest checking                               |  | $              | 12,637  |   |                         |   | 50         |      | 0.40 | %              |  | $ | 12,538                 |   |            |   | 116    |                | 0.92 | % |                         | $ | 10,513     |   |  | $ | 204    |  | 1.94 | %
|Savings deposits                                |  |                | 35,177  |   |                         |   | 562        |      | 1.60 | %              |  |   | 29,053                 |   |            |   | 675    |                | 2.32 | % |                         |   | 20,195     |   |  |   | 620    |  | 3.07 | %
|Time deposits                                   |  |                | 71,444  |   |                         |   | 2,513      |      | 3.52 | %              |  |   | 75,989                 |   |            |   | 3,286  |                | 4.32 | % |                         |   | 77,663     |   |  |   | 4,423  |  | 5.70 | %
|Large denomination deposits                     |  |                | 21,531  |   |                         |   | 656        |      | 3.05 | %              |  |   | 23,518                 |   |            |   | 888    |                | 3.78 | % |                         |   | 23,629     |   |  |   | 1,224  |  | 5.18 | %
|Securities purchased under agreements to resell |  |                | 1,263   |   |                         |   | 28         |      | 2.22 | %              |  |   |                       |   |            |   |       |                |     |   |                         |   |           |   |  |   |       |  |     |  
|Federal Home Loan Bank borrowings               |  |                |        |   |                         |   |           |      |     |                |  |   |                       |   |            |   |       |                |     |   |                         |   | 164        |   |  |   | 3      |  | 1.83 | %
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Total interest-bearing liabilities              |  |                | 142,052 |   |                         |   | 3,809      |      | 2.68 | %              |  |   | 141,098                |   |            |   | 4,965  |                | 3.52 | % |                         |   | 132,164    |   |  |   | 6,474  |  | 4.90 | %
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Noninterest-bearing liabilities:                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Demand deposits                                 |  |                | 22,068  |   |                         |   |            |      |      |                |  |   | 20,184                 |   |            |   |        |                |      |   |                         |   | 19,020     |   |  |   |        |  |      |  
|Other liabilities                               |  |                | 660     |   |                         |   |            |      |      |                |  |   | 823                    |   |            |   |        |                |      |   |                         |   | 1,463      |   |  |   |        |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Total liabilities                               |  |                | 164,780 |   |                         |   |            |      |      |                |  |   | 162,105                |   |            |   |        |                |      |   |                         |   | 152,647    |   |  |   |        |  |      |  
|Stockholders equity                            |  |                | 24,051  |   |                         |   |            |      |      |                |  |   | 22,451                 |   |            |   |        |                |      |   |                         |   | 20,953     |   |  |   |        |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Total liabilities and stockholders equity      |  | $              | 188,831 |   |                         |   |            |      |      |                |  | $ | 184,556                |   |            |   |        |                |      |   |                         | $ | 173,600    |   |  |   |        |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Net interest earnings                           |  |                |         |   |                         | $ | 6,380      |      |      |                |  |   |                        |   |            | $ | 6,760  |                |      |   |                         |   |            |   |  | $ | 6,431  |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Net interest spread (1)                         |  |                |         |   |                         |   |            |      | 3.02 | %              |  |   |                        |   |            |   |        |                | 3.16 | % |                         |   |            |   |  |   |        |  | 2.91 | %
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Net interest margin (2)                         |  |                |         |   |                         |   |            |      | 3.57 | %              |  |   |                        |   |            |   |        |                | 3.85 | % |                         |   |            |   |  |   |        |  | 3.89 | %
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  
|Taxable equivalent adjustment                   |  |                |         |   |                         | $ | 314        |      |      |                |  |   |                        |   |            | $ | 320    |                |      |   |                         |   |            |   |  | $ | 333    |  |      |  
|                                                |  |                |         |   |                         |   |            |      |      |                |  |   |                        |   |            |   |        |                |      |   |                         |   |            |   |  |   |        |  |      |  



---



|(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



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---



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,
2003, 2002 and 2001. 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 $6.4 million, a
decrease of 5.6%, or $380 thousand from the $6.7 million in 2002. The net interest margin was 3.57% for 2003, down 28 basis points from the 3.85% reported in 2002. While the overall yield on earning assets declined 97 basis points, the effect of the
84 basis point drop in cost of funds served to partially offset the lower yield on earning assets and support the net interest margin.



As illustrated in Table 2, the effect of the overall lowering of interest rates on the variable or floating rate portion of the Companys loan portfolio, as it
re-prices in the current declining rate environment, is evident in the $1.7 million reduction in loan interest income due to rate. The net increase in loan volume did, however, serve to offset this decline by approximately fifty percent as $821
thousand in income was contributed by the volume increase.



The other asset
category that had a marked impact on interest earnings was the reduction in the Companys investment securities portfolio. Issuer calls of securities, principally U.S. Government Agency securities, totaling approximately $8.8 million, and
increased speeds with which homeowners paid down their mortgages resulted in a decline of over $11 million in the mortgage-backed securities portfolio, which resulted in lower interest income due to these changes in volume of $158 thousand. Over $18
million in investment securities were purchased during 2003, however, since these securities bear the lower rates present in the current market, they contributed to the $373 thousand reduction in investment interest income due to rate.



During 2003, average federal funds sold and average interest bearing deposits held at the
Federal Home Loan Bank were lowered by $2.9 million to $17.7 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 increased $954 thousand to $142.1 million for the
year 2003. Total interest-bearing deposits declined $309 thousand to $140.8 million predominantly due to a shift of approximately $1.3 million in average deposits to securities sold under agreements to repurchase. The remainder of 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.



4



---

---



Managements Discussion and Analysis



---



---

Table 2. Rate/Volume Variance Analysis



---



|                                                    |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|--------------------------------------------------- |  | --------------------- | ------ | - | ------------------------- | - | ------ | ------ |  | - | ------------------------- | - |  | ---- | ------ | - | ------ | - | ------ | - |  | - | ---- | -
|                                                    |  | 2003 Compared to 2002 |        |   | 2002 Compared to 2001     |  
|                                                    |  |                       |        |   | Increase (Decrease)Due To |   |        |        |  |   | Increase (Decrease)Due To |  
|(In thousands)                                      |  | Total                 |        |   | Rate                      |   |        | Volume |  |   | Total                     |   |  | Rate |        |   | Volume |  
|Interest-earning assets:                            |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|Deposits in other banks                             |  | $                     | (50    | ) |                           | $ | (44    | )      |  | $ | (6                        | ) |  | $    | 70     |   |        | $ | (84    | ) |  | $ | 154  |  
|Taxable investment securities                       |  |                       | (472   | ) |                           |   | (352   | )      |  |   | (120                      | ) |  |      | (483   | ) |        |   | (238   | ) |  |   | (245 | )
|Nontaxable investment securities                    |  |                       | (59    | ) |                           |   | (21    | )      |  |   | (38                       | ) |  |      | 25     |   |        |   | 19     |   |  |   | 6    |  
|Federal funds sold                                  |  |                       | (89    | ) |                           |   | (55    | )      |  |   | (34                       | ) |  |      | (69    | ) |        |   | (295   | ) |  |   | 226  |  
|Loans                                               |  |                       | (866   | ) |                           |   | (1,687 | )      |  |   | 821                       |   |  |      | (723   | ) |        |   | (946   | ) |  |   | 223  |  
|                                                    |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|Total                                               |  |                       | (1,536 | ) |                           |   | (2,159 | )      |  |   | 623                       |   |  |      | (1,180 | ) |        |   | (1,544 | ) |  |   | 364  |  
|                                                    |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|Interest-bearing liabilities:                       |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|Interest checking                                   |  |                       | (66    | ) |                           |   | (67    | )      |  |   | 1                         |   |  |      | (88    | ) |        |   | (127   | ) |  |   | 39   |  
|Savings deposits                                    |  |                       | (113   | ) |                           |   | (348   | )      |  |   | 235                       |   |  |      | 55     |   |        |   | (217   | ) |  |   | 272  |  
|Time deposits                                       |  |                       | (773   | ) |                           |   | (585   | )      |  |   | (188                      | ) |  |      | (1,137 | ) |        |   | (1,042 | ) |  |   | (95  | )
|Large denomination deposits                         |  |                       | (232   | ) |                           |   | (161   | )      |  |   | (71                       | ) |  |      | (336   | ) |        |   | (330   | ) |  |   | (6   | )
|Federal Home Loan Bank borrowings                   |  |                       |       |   |                           |   |       |        |  |   |                          |   |  |      | (3     | ) |        |   |       |   |  |   | (3   | )
|Securities purchased under agreements to repurchase |  |                       | 28     |   |                           |   |       |        |  |   | 28                        |   |  |      |       |   |        |   |       |   |  |   |     |  
|                                                    |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|Total                                               |  |                       | (1,156 | ) |                           |   | (1,161 | )      |  |   | (5                        | ) |  |      | (1,509 | ) |        |   | (1,716 | ) |  |   | 207  |  
|                                                    |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  
|Net interest income                                 |  | $                     | (380   | ) |                           | $ | (998   | )      |  | $ | 628                       |   |  | $    | 329    |   |        | $ | 172    |   |  | $ | 157  |  
|                                                    |  |                       |        |   |                           |   |        |        |  |   |                           |   |  |      |        |   |        |   |        |   |  |   |      |  



---





5



---

---



Managements Discussion and Analysis



---



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 2003, the provision for loan losses was $30
thousand, a decrease of $345 thousand from the $375 thousand recorded in 2002. Based upon managements periodic reviews of the loan portfolio using the above mentioned factors, the current year decrease in the provision for loan losses was felt
appropriate. Management believes the provision recorded in 2003 maintains the allowance at a level adequate to cover potential losses. The allowance for loan losses as a percentage of total loans was 1.41% at year-end. This level compares favorably
to the 1.35% ratio averaged at year-end 2003 by the Companys peer group, commercial banks with assets ranging between $100 million and $300 million. Loan charge-offs, net of recoveries, were $102 thousand for 2003, compared to net recoveries
of $94 thousand for 2002. 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 $874 thousand in 2003, an increase of $68 thousand from the $806 thousand recorded in 2002. The largest increase
in noninterest income resulted from income generated by the Companys investment in bank owned life insurance. The primary sources of noninterest income for the past three years are summarized in Table 3 below.



---



Table 3. Noninterest Income



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|                                       |  |      |     |      |   |      |  |   |    
|-------------------------------------- |  | ---- | --- | ---- | - | ---- |  | - | ---
|Year ended December 31, (In thousands) |  | 2003 |     | 2002 |   | 2001
|Deposit fees and charges               |  | $    | 308 |      | $ | 312  |  | $ | 281
|Other service charges and fees         |  |      | 86  |      |   | 81   |  |   | 77 
|Gain on the sale of securities         |  |      |    |      |   | 24   |  |   | 44 
|Bank owned life insurance              |  |      | 178 |      |   | 149  |  |   |   
|Other income                           |  |      | 302 |      |   | 240  |  |   | 192
|                                       |  |      |     |      |   |      |  |   |    
|Total noninterest income               |  | $    | 874 |      | $ | 806  |  | $ | 594
|                                       |  |      |     |      |   |      |  |   |    



---





6



---

---



Managements Discussion and Analysis



---



Noninterest Expense



Noninterest expense was $4.3 million for 2003, an increase of $566 thousand over the $3.8 million recorded in 2002. As mentioned earlier, expenses related to the proposed
merger with MountainBank Financial Corporation that was not ratified in early 2003 by the Registrants shareholders, and the legal expense incurred regarding the matter related to the former employee accounted for the largest portion of the
increase in noninterest expense. Increased pension expense and higher salaries and benefits costs accounted for most of the remaining year-to-year increase. Cost of living increases and higher medical insurance costs were the primary cause of higher
salary and benefits costs.



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



---



Table 4. Noninterest Expense



---



|                                       |  |      |       |      |   |       |  |   |      
|-------------------------------------- |  | ---- | ----- | ---- | - | ----- |  | - | -----
|Year ended December 31, (In thousands) |  | 2003 |       | 2002 |   | 2001 
|Salaries and employee benefits         |  | $    | 2,479 |      | $ | 2,272 |  | $ | 2,160
|Occupancy and equipment                |  |      | 553   |      |   | 541   |  |   | 523  
|Legal and professional                 |  |      | 528   |      |   | 189   |  |   | 91   
|Bank franchise tax                     |  |      | 114   |      |   | 110   |  |   | 108  
|Other operating expense                |  |      | 648   |      |   | 644   |  |   | 646  
|                                       |  |      |       |      |   |       |  |   |      
|Total noninterest expense              |  | $    | 4,322 |      | $ | 3,756 |  | $ | 3,528
|                                       |  |      |       |      |   |       |  |   |      



---



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 $562 thousand in 2003, $729 thousand in 2002 and $632 thousand in 2001 representing 21.7%, 23.4% and 23.2% 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 $513 thousand and $510 thousand at December 31, 2003 and 2002, respectively, are included in other assets.



7



---

---



Managements Discussion and Analysis



---



Earning Assets



In 2003, average earning assets increased to $178.6 million, $3.1 million higher than the 2002 average of $175.5 million. Total average earning assets represented 94.6%
of total average assets in 2003. Increases in average loans accounted for the net increase in total average earning assets of 1.8%, as other earning asset categories reflected net reductions year-to-year. Average investment securities accounted for
22.8% of total average assets, while average net loans remained the largest component of earning assets, accounting for 62.4% of total average assets in 2003, up slightly from the 59.0% level reported in 2002. A summary of average assets for the
past three years is shown below in Table 5.



---



Table 5. Average Asset Mix



---



|                                       |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|-------------------------------------- |  | -------------- | ------- | ---- | ----- | -------------- | - | ------- |  | -------------- |  | - | ------- |  | ------
|Year ended December 31, (In thousands) |  | 2003           |         | 2002 |       | 2001          
|                                       |  | AverageBalance |         | %    |       | AverageBalance |   | %       |  | AverageBalance |  | %
|Interest-earning assets:               |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|Loans                                  |  | $              | 117,795 |      | 62.4  |                | $ | 108,898 |  | 59.0           |  | $ | 106,368 |  | 61.3  
|Investment securities                  |  |                | 43,054  |      | 22.8  |                |   | 45,977  |  | 24.9           |  |   | 49,670  |  | 28.6  
|Federal funds sold                     |  |                | 11,354  |      | 6.0   |                |   | 13,884  |  | 7.5            |  |   | 7,644   |  | 4.4   
|Deposits in other banks                |  |                | 6,350   |      | 3.4   |                |   | 6,707   |  | 3.7            |  |   | 1,620   |  | 0.9   
|                                       |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|Total interest-earning assets          |  |                | 178,553 |      | 94.6  |                |   | 175,466 |  | 95.1           |  |   | 165,302 |  | 95.2  
|                                       |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|                                       |  |                |         |      |       |               
|Noninterest-earning assets:            |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|Cash and due from banks                |  |                | 3,350   |      | 1.8   |                |   | 3,027   |  | 1.6            |  |   | 3,567   |  | 2.1   
|Premises and equipment                 |  |                | 2,172   |      | 1.1   |                |   | 2,263   |  | 1.2            |  |   | 2,534   |  | 1.4   
|Other assets                           |  |                | 4,756   |      | 2.5   |                |   | 3,800   |  | 2.1            |  |   | 2,197   |  | 1.3   
|                                       |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|Total noninterest-earning assets       |  |                | 10,278  |      | 5.4   |                |   | 9,090   |  | 4.9            |  |   | 8,298   |  | 4.8   
|                                       |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       
|Total assets                           |  | $              | 188,831 |      | 100.0 |                | $ | 184,556 |  | 100.0          |  | $ | 173,600 |  | 100.00
|                                       |  |                |         |      |       |                |   |         |  |                |  |   |         |  |       



---



Loans



Average total loans were $117.8 million for 2003, an increase of $8.9 million, or 8.2% over 2002. At December 31, 2003, the actual balance of loans secured by real estate
represented the most significant portion of the loan portfolio at 92.3%. Total loans secured by 1-4 family residential properties represented 25.1% of total loans at the end of 2003, while nonfarm/nonresidential properties made up 54.5% of total
loans. These loan portfolio proportions remained relatively unchanged from year-end 2002 levels.



Loan growth will continue to be a point of focus at Cardinal for 2004. 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 and home equity lines of credit, and managements strenthened efforts in
offering small business financing and competively-priced products. Prudent business practices and stingent 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.



8



---

---



Managements Discussion and Analysis



---



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 and Christiansburg, Virginia. The Bank places emphasis on
consumer based installment loans and commercial loans to small and medium sized businesses. Predatory 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 2003 and 2002, and the maturity distribution of variable and fixed rate loans as of year-end 2003 are presented below in Table 6 and Table 7, respectively.



---



Table 6.
Loan Portfolio Summary



---



|                                         |  |        |         |   |      |       |   |        |   |         |   |  |       |  
|---------------------------------------- |  | ------ | ------- | - | ---- | ----- | - | ------ | - | ------- | - |  | ----- | -
|December 31, (In thousands)              |  | 2003   |         |   | 2002 |      
|                                         |  | Amount |         |   | %    |       |   | Amount |   |         | % | 
|Real estate construction and development |  | $      | 7,212   |   |      | 6.0   |   |        | $ | 2,188   |   |  | 1.9   |  
|Farmland                                 |  |        | 3,303   |   |      | 2.7   |   |        |   | 3,148   |   |  | 2.7   |  
|Real estate mortgage:                    |  |        |         |   |      |       |   |        |   |         |   |  |       |  
|1-4 family residential                   |  |        | 30,293  |   |      | 25.1  |   |        |   | 29,812  |   |  | 25.9  |  
|Multifamily residential                  |  |        | 4,880   |   |      | 4.0   |   |        |   | 3,237   |   |  | 2.8   |  
|Nonfarm, nonresidential                  |  |        | 65,732  |   |      | 54.5  |   |        |   | 65,893  |   |  | 57.3  |  
|                                         |  |        |         |   |      |       |   |        |   |         |   |  |       |  
|Total real estate                        |  |        | 111,420 |   |      | 92.3  |   |        |   | 104,278 |   |  | 90.6  |  
|                                         |  |        |         |  
|Agricultural                             |  |        | 813     |   |      | 0.7   |   |        |   | 1,082   |   |  | 0.9   |  
|Commercial and industrial                |  |        | 6,163   |   |      | 5.1   |   |        |   | 6,773   |   |  | 5.9   |  
|Consumer                                 |  |        | 2,568   |   |      | 2.1   |   |        |   | 3,068   |   |  | 2.7   |  
|Other loans                              |  |        | 63      |   |      | 0.1   |   |        |   | 87      |   |  | 0.1   |  
|Leases                                   |  |        | 30      |   |      | 0.0   |   |        |   | 143     |   |  | 0.1   |  
|                                         |  |        |         |   |      |       |   |        |   |         |   |  |       |  
|Gross loans                              |  |        | 121,057 |   |      |       |   |        |   | 115,431 |   |  |       |  
|                                         |  |        |         |   |      |       |   |        |   |         |   |  |       |  
|Unearned income                          |  |        | (327    | ) |      | (0.3  | ) |        |   | (338    | ) |  | (0.3  | )
|                                         |  |        |         |   |      |       |   |        |   |         |   |  |       |  
|Total                                    |  | $      | 120,730 |   |      | 100.0 |   |        | $ | 115,093 |   |  | 100.0 |  
|                                         |  |        |         |   |      |       |   |        |   |         |   |  |       |  



---



9



---

---



Managements Discussion and Analysis



---



---



Table 7.
Loan Maturity Schedule



---



|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|------------------------------------ |  | ----------------------------------- | ------ | -------------------------- | - | ------ |  | ----------- | ------- | - | - | ------- |  | -----
|                                     |  | 2003                               
|(In thousands)                       |  | CommercialFinanical andAgricultural |        | ConstructionandDevelopment |   | Others |  | TotalAmount |         | %
|Fixed rate loans:                    |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Within three months                  |  | $                                   | 40     |                            | $ | 121    |  | $           | 1,543   |   | $ | 1,704   |  | 1.4  
|After three but within twelve months |  |                                     | 2,418  |                            |   | 237    |  |             | 9,739   |   |   | 12,394  |  | 10.3 
|After one but within five years      |  |                                     | 2,020  |                            |   | 1,000  |  |             | 11,032  |   |   | 14,052  |  | 11.6 
|Over five years                      |  |                                     | 549    |                            |   | 865    |  |             | 27,059  |   |   | 28,473  |  | 23.5 
|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Total fixed rate loans               |  |                                     | 5,027  |                            |   | 2,223  |  |             | 49,373  |   |   | 56,623  |  | 46.8 
|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Variable rate loans:                 |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Within three month                   |  |                                     | 3,138  |                            |   | 2,243  |  |             | 15,226  |   |   | 20,607  |  | 17.0 
|After three but within twelve months |  |                                     | 1,043  |                            |   |       |  |             | 10,583  |   |   | 11,626  |  | 9.6  
|After one but within five years      |  |                                     | 1,101  |                            |   | 2,313  |  |             | 25,647  |   |   | 29,061  |  | 24.0 
|Over five years                      |  |                                     |       |                            |   | 433    |  |             | 2,707   |   |   | 3,140   |  | 2.6  
|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Total variable rate loans            |  |                                     | 5,282  |                            |   | 4,989  |  |             | 54,163  |   |   | 64,434  |  | 53.2 
|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Total loans:                         |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Within three month                   |  |                                     | 3,178  |                            |   | 2,364  |  |             | 16,769  |   |   | 22,311  |  | 18.4 
|After three but within twelve months |  |                                     | 3,461  |                            |   | 237    |  |             | 20,322  |   |   | 24,020  |  | 19.9 
|After one but within five years      |  |                                     | 3,121  |                            |   | 3,313  |  |             | 36,679  |   |   | 43,113  |  | 35.6 
|Over five years                      |  |                                     | 549    |                            |   | 1,298  |  |             | 29,766  |   |   | 31,613  |  | 26.1 
|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      
|Total loans                          |  | $                                   | 10,309 |                            | $ | 7,212  |  | $           | 103,536 |   | $ | 121,057 |  | 100.0
|                                     |  |                                     |        |                            |   |        |  |             |         |   |   |         |  |      



---



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, 2003, the Company had $21.8 million in securities available for sale, compared to $28.0 million at year-end 2002. The yield on taxable investment
securities declined from 5.54% in 2002 to 4.08% in 2003 as a result of maturities and calls of higher yielding securities. Taxable investment securities purchased during 2003 in order to maintain the portfolio at desired mix and volume levels,
reflected the lower current market rate of interest which reduced the average yield.



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 2003 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.



10



---

---



Managements Discussion and Analysis



---



At December 31, 2003, the market value of the investment portfolio was $41.3 million, representing a $1.3 million unrealized appreciation
above amortized cost. This compared to a market value of $46.0 million and a $1.4 million appreciation above amortized cost a year earlier.



---



Table 8. Investment Securities



---



|                                                        |  |                    |      |   |                            |   |       |                            |  |   |                |   |  |       |        |   |             |   |        |   |  |   |       
|------------------------------------------------------- |  | ------------------ | ---- | - | -------------------------- | - | ----- | -------------------------- |  | - | -------------- | - |  | ----- | ------ | - | ----------- | - | ------ | - |  | - | ------
|December 31, 2003 (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   |  | $                  | 29   |   |                            | $ | 3,897 |                            |  | $ | 1,100          |   |  | $     | 13,252 |   |             | $ | 18,278 |   |  | $ | 18,336
|State and political subdivisions                        |  |                    | 665  |   |                            |   | 5,624 |                            |  |   | 8,141          |   |  |       | 5,335  |   |             |   | 19,765 |   |  |   | 20,885
|Other securities                                        |  |                    |     |   |                            |   |      |                            |  |   |               |   |  |       | 1,982  |   |             |   | 1,982  |   |  |   | 2,114 
|                                                        |  |                    |      |   |                            |   |       |                            |  |   |                |   |  |       |        |   |             |   |        |   |  |   |       
|Total                                                   |  | $                  | 694  |   |                            | $ | 9,521 |                            |  | $ | 9,241          |   |  | $     | 20,569 |   |             | $ | 40,025 |   |  | $ | 41,335
|                                                        |  |                    |      |   |                            |   |       |                            |  |   |                |   |  |       |        |   |             |   |        |   |  |   |       
|Weighted average yields                                 |  |                    |      |   |                            |   |       |                            |  |   |                |   |  |       |        |   |             |   |        |   |  |   |       
|U.S. Government agencies and mortgage backed securities |  |                    | 8.60 | % |                            |   | 2.72  | %                          |  |   | 4.10           | % |  |       | 4.56   | % |             |   |        |   |  |   |       
|States and political subsdivisions                      |  |                    | 4.22 | % |                            |   | 4.60  | %                          |  |   | 4.58           | % |  |       | 4.74   | % |             |   |        |   |  |   |       
|Other securities                                        |  |                    |     | % |                            |   |      | %                          |  |   |               | % |  |       | 7.25   | % |             |   |        |   |  |   |       
|                                                        |  |                    |      |   |                            |   |       |                            |  |   |                |   |  |       |        |   |             |   |        |   |  |   |       
|Total securities                                        |  |                    | 4.40 | % |                            |   | 3.83  | %                          |  |   | 4.52           | % |  |       | 4.87   | % |             |   | 4.53   | % |  |   |       
|                                                        |  |                    |      |   |                            |   |       |                            |  |   |                |   |  |       |        |   |             |   |        |   |  |   |       



|                                                        |  |            |        |              |   |       
|------------------------------------------------------- |  | ---------- | ------ | ------------ | - | ------
|December 31, 2002                                       |  | Book Value |        | Market Value
|Investment securities                                   |  |            |        |              |   |       
|U.S. Government agencies and mortgage backed securities |  | $          | 22,436 |              | $ | 22,774
|States and political subdivisions                       |  |            | 19,646 |              |   | 20,734
|Other securities                                        |  |            | 2,499  |              |   | 2,499 
|                                                        |  |            |        |              |   |       
|Total                                                   |  | $          | 44,581 |              | $ | 46,007
|                                                        |  |            |        |              |   |       



---



11



---

---



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, 2003 rose $1.6 million to $162.9 million compared to 2002. As shown in Table 9, the Companys average interest-bearing deposits as a percent of total average
deposits increased to 86.5% in 2003, compared to 87.5% in 2002. Average noninterest-bearing demand deposits also increased to $22.1 million in 2003 from $20.2 million in 2002. Average deposits for the past three years are summarized in Table 9
below.



---



Table 9. Deposit Mix



---



|                                |  |                |         |      |        |                |   |         |  |                |  |   |         |  |       
|------------------------------- |  | -------------- | ------- | ---- | ------ | -------------- | - | ------- |  | -------------- |  | - | ------- |  | ------
|December 31, (In thousands)     |  | 2003           |         | 2002 |        | 2001          
|                                |  | AverageBalance |         | %    |        | AverageBalance |   | %       |  | AverageBalance |  | %
|Interest-bearing deposits:      |  |                |         |      |        |                |   |         |  |                |  |   |         |  |       
|Interest checking               |  | $              | 12,637  |      | 7.76   |                | $ | 12,538  |  | 7.77           |  | $ | 10,513  |  | 6.96  
|Money Market                    |  |                | 5,634   |      | 3.46   |                |   | 7,629   |  | 4.73           |  |   | 6,163   |  | 4.08  
|Savings deposits                |  |                | 29,543  |      | 18.14  |                |   | 21,424  |  | 13.29          |  |   | 14,032  |  | 9.29  
|Time deposits                   |  |                | 71,444  |      | 43.87  |                |   | 75,989  |  | 47.12          |  |   | 77,663  |  | 51.43 
|Large denomination deposits     |  |                | 21,531  |      | 13.22  |                |   | 23,518  |  | 14.58          |  |   | 23,629  |  | 15.65 
|                                |  |                |         |      |        |                |   |         |  |                |  |   |         |  |       
|Total interest-bearing deposits |  |                | 140,789 |      | 86.45  |                |   | 141,098 |  | 87.49          |  |   | 132,000 |  | 87.41 
|Noninterest-bearing deposits    |  |                | 22,068  |      | 13.55  |                |   | 20,184  |  | 12.51          |  |   | 19,020  |  | 12.59 
|                                |  |                |         |      |        |                |   |         |  |                |  |   |         |  |       
|Total deposits                  |  | $              | 162,857 |      | 100.00 |                | $ | 161,282 |  | 100.00         |  | $ | 151,020 |  | 100.00
|                                |  |                |         |      |        |                |   |         |  |                |  |   |         |  |       



---



The average balance of certificates of deposit issued in denominations of $100,000 or more declined by approximately $2 million in 2003 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, 2003.





12



---

---



Managements Discussion and Analysis



---



---



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



---



Analysis of time deposits of $100,000 or more at December 31, 2003 (In thousands):



|                                        |  |   |       
|--------------------------------------- |  | - | ------
|Time remaining to maturity:             |  |   |       
|Less than three months                  |  | $ | 1,499 
|Three through one year                  |  |   | 5,902 
|Over one year                           |  |   | 9,733 
|                                        |  |   |       
|Total time deposits of $100,000 or more |  | $ | 17,134
|                                        |  |   |       



---

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 $24.5 million at December 31, 2003, an increase of $1.2 million or 5.3% compared with $23.2 million for the same period in 2002.



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 20.37% at December 31, 2003 and a ratio of Tier 1 capital to risk-weighted assets of 19.12%. 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, 2003, Cardinal Bankshares
had a ratio of year-end Tier I capital to average total assets, as defined, of 12.95%.



Table 11 below sets forth summary information with respect to the capital ratios for Cardinal and the Bank at December 31, 2003. All capital ratio levels indicate that Cardinal Bankshares and Bank of Floyd are well capitalized.



13



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Managements Discussion and Analysis



---



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Table 11. Year-end Risk-based Capital



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|                                                                                |  |              |         |   |               |   |         |              |  |   |              |   |  |   |         |  
|------------------------------------------------------------------------------- |  | ------------ | ------- | - | ------------- | - | ------- | ------------ |  | - | ------------ | - |  | - | ------- | -
|December 31, (In thousands)                                                     |  | 2003         |         |   | 2002          |  
|                                                                                |  | Consolidated |         |   | Bank of Floyd |   |         | Consolidated |  |   | Bank ofFloyd |  
|Tier I capital                                                                  |  | $            | 24,252  |   |               | $ | 15,759  |              |  | $ | 22,949       |   |  | $ | 14,124  |  
|Qualifying allowance for loan losses (limited to 1.25% of risk-weighted assets) |  |              | 1,587   |   |               |   | 1,520   |              |  |   | 1,550        |   |  |   | 1,507   |  
|                                                                                |  |              |         |   |               |   |         |              |  |   |              |   |  |   |         |  
|Total regulatory capital                                                        |  | $            | 25,839  |   |               | $ | 17,279  |              |  | $ | 24,499       |   |  | $ | 15,631  |  
|                                                                                |  |              |         |   |               |   |         |              |  |   |              |   |  |   |         |  
|Total risk-weighted assets                                                      |  | $            | 126,839 |   |               | $ | 121,602 |              |  | $ | 123,752      |   |  | $ | 120,351 |  
|                                                                                |  |              |         |   |               |   |         |              |  |   |              |   |  |   |         |  
|Tier I as a percent of risk-weighted assets                                     |  |              | 19.12   | % |               |   | 12.96   | %            |  |   | 18.54        | % |  |   | 11.74   | %
|Total regulatory capital as a percent of risk-weighted assets                   |  |              | 20.37   | % |               |   | 14.21   | %            |  |   | 19.80        | % |  |   | 12.99   | %
|Leverage ratio*                                                                 |  |              | 12.95   | % |               |   | 8.65    | %            |  |   | 12.37        | % |  |   | 7.77    | %



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



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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, increased to $3.2 million at December 31, 2003 from $755 thousand at December 31, 2002. This increase was the result of one loan being placed on nonaccrual status during the year. Management
is working closely with the borrowers to address the issues which caused the credit to be classifed as nonaccrual. Based on the progress made management is optomistic that the issues will be satisfactorily resolved. The loan is eighty percent
guranteed by the U.S. Government and is well collateralized. Accordingly, management does not anticipate any significant loss with respect to this loan. At year-end 2003, loans past due 90 days or more had declined $85 thousand from $100 thousand a
year earlier. Foreclosed assets also declined to $383 thousand, almost 40% lower than the year-end 2003 level.



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Table 12. Nonperforming Assets



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|                               |  |      |       |      |   |    
|------------------------------ |  | ---- | ----- | ---- | - | ---
|December 31 (In thousands)     |  | 2003 |       | 2002
|Nonaccrual loans               |  | $    | 2,774 |      | $ |   
|Loans past due 90 days or more |  |      | 15    |      |   | 100
|Foreclosed properties          |  |      | 383   |      |   | 655
|                               |  |      |       |      |   |    
|Total nonperforming assets     |  | $    | 3,172 |      | $ | 755
|                               |  |      |       |      |   |    



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14



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Managements Discussion and Analysis



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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 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 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 $1.7 million at December 31, 2003 and $1.8 million at December 31, 2002. The allowance as a percentage of period end loans was 1.41% at year-end 2003 and
1.54% at year-end 2002.



The provision for loan losses for the year ended
December 31, 2003 was $30 thousand, a decrease of $345 thousand from the previous year. Based upon managements periodic reviews of the loan portfolio using the above mentioned factors, the current year decrease in the provision was considered
appropriate. Management believes the provision recorded in 2003 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.



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Table 13. Loan Losses



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|                                            |  |      |       |      |   |       |      |  |   |      
|------------------------------------------- |  | ---- | ----- | ---- | - | ----- | ---- |  | - | -----
|Year ended December 31, (In thousands)      |  | 2003 |       | 2002 |   |       | 2001
|Balance at beginning of year                |  | $    | 1,769 |      | $ | 1,300 |      |  | $ | 1,134
|Provision charged to expense                |  |      | 30    |      |   | 375   |      |  |   | 442  
|                                            |  |      |       |      |   |       |      |  |   |      
|                                            |  |      | 1,799 |      |   | 1,675 |      |  |   | 1,576
|Loans charged off:                          |  |      |       |      |   |       |      |  |   |      
|Commercial, financial and agricultural      |  |      | 68    |      |   | 44    |      |  |   | 322  
|Real estate  mortgage                      |  |      |      |      |   | 27    |      |  |   |     
|Real estate  construction                  |  |      |      |      |   |      |      |  |   | 129  
|Consumer                                    |  |      | 64    |      |   | 25    |      |  |   | 33   
|                                            |  |      |       |      |   |       |      |  |   |      
|Total charge-offs                           |  |      | 132   |      |   | 96    |      |  |   | 484  
|                                            |  |      |       |      |   |       |      |  |   |      
|Recoveries of loans previously charged off: |  |      |       |      |   |       |      |  |   |      
|Commercial, financial and agricultural      |  |      | 26    |      |   | 186   |      |  |   | 205  
|Real estate  residential mortgage          |  |      |      |      |   |      |      |  |   |     
|Real estate  construction                  |  |      |      |      |   |      |      |  |   |     
|Consumer                                    |  |      | 4     |      |   | 4     |      |  |   | 3    
|                                            |  |      |       |      |   |       |      |  |   |      
|Total recoveries                            |  |      | 30    |      |   | 190   |      |  |   | 208  
|                                            |  |      |       |      |   |       |      |  |   |      
|Net (recoveries) charge  offs              |  |      | 102   |      |   | (94   | )    |  |   | 276  
|                                            |  |      |       |      |   |       |      |  |   |      
|Balance at end of year                      |  | $    | 1,697 |      | $ | 1,769 |      |  | $ | 1,300
|                                            |  |      |       |      |   |       |      |  |   |      



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15



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Managements Discussion and Analysis



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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.



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Table 14. Allocation of the Allowance for Loan Losses



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|                                        |  |        |       |          |       |        |   |          |  |        |  |          |       |  |      
|--------------------------------------- |  | ------ | ----- | -------- | ----- | ------ | - | -------- |  | ------ |  | -------- | ----- |  | -----
|December 31, (In thousands)             |  | 2003   |       | 2002     |       | 2001  
|                                        |  | Amount |       | Percent1 |       | Amount |   | Percent1 |  | Amount |  | Percent1
|Balance at end of period applicable to: |  |        |       |          |       |        |   |          |  |        |  |          |       |  |      
|Commercial, financial and agricultural  |  | $      | 1,013 |          | 62.8  |        | $ | 502      |  | 66.6   |  | $        | 693   |  | 57.0 
|Real estate, construction               |  |        | 69    |          | 6.0   |        |   | 65       |  | 1.9    |  |          | 118   |  | 11.5 
|Real estate, mortgage                   |  |        | 569   |          | 29.1  |        |   | 657      |  | 28.7   |  |          | 384   |  | 27.3 
|Consumer loans                          |  |        | 46    |          | 2.1   |        |   | 510      |  | 2.7    |  |          | 43    |  | 3.8  
|Leases                                  |  |        |      |          |      |        |   | 35       |  | 0.1    |  |          | 62    |  | 0.4  
|                                        |  |        |       |          |       |        |   |          |  |        |  |          |       |  |      
|Total                                   |  | $      | 1,697 |          | 100.0 |        | $ | 1,769    |  | 100.0  |  | $        | 1,300 |  | 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.



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.



16



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---



Managements Discussion and Analysis



---



---



Table 15.
Interest Rate Sensitivity



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|                                                 |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|------------------------------------------------ |  | -------------------------------------- | ------- | -- | ---------- | - | ------- | ----------- |  | - | ------------- | -- |  | ----- | ------ | - |  | - | ------- | -
|                                                 |  | December 31, 2003 Maturities/Repricing |        
|(In thousands)                                   |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |       
|                                                 |  | 1-3Months                              |         |    | 4-12Months |   |         | 13-60Months |  |   | Over 60Months |    |  | Total |       
|Earning Assets:                                  |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|Loans                                            |  | $                                      | 22,311  |    |            | $ | 24,020  |             |  | $ | 43,113        |    |  | $     | 31,613 |   |  | $ | 121,057 |  
|Investments                                      |  |                                        | 665     |    |            |   | 29      |             |  |   | 9,521         |    |  |       | 29,810 |   |  |   | 40,025  |  
|Federal funds sold                               |  |                                        | 9,125   |    |            |   |        |             |  |   |              |    |  |       |       |   |  |   | 9,125   |  
|                                                 |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|Total                                            |  | $                                      | 32,101  |    |            | $ | 24,049  |             |  | $ | 52,634        |    |  | $     | 61,423 |   |  | $ | 170,207 |  
|                                                 |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|Interest-bearing deposits:                       |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|Interest checking                                |  | $                                      | 13,500  |    |            | $ |        |             |  | $ |              |    |  | $     |       |   |  | $ | 13,500  |  
|Money market                                     |  |                                        | 4,493   |    |            |   |        |             |  |   |              |    |  |       |       |   |  |   | 4,493   |  
|Savings                                          |  |                                        | 33,981  |    |            |   | 117     |             |  |   |              |    |  |       |       |   |  |   | 34,098  |  
|Certificates of deposit                          |  |                                        | 8,885   |    |            |   | 32,608  |             |  |   | 42,672        |    |  |       |       |   |  |   | 84,165  |  
|Securities sold under agreements to repurchase   |  |                                        | 1,826   |    |            |   |        |             |  |   |              |    |  |       |       |   |  |   | 1,826   |  
|                                                 |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|Total                                            |  | $                                      | 62,685  |    |            | $ | 32,725  |             |  | $ | 42,672        |    |  | $     |       |   |  | $ | 138,082 |  
|                                                 |  |                                        |         |    |            |   |         |             |  |   |               |    |  |       |        |   |  |   |         |  
|Interest sensitivity gap                         |  | $                                      | (30,584 | )  |            | $ | (8,676  | )           |  | $ | 9,962         |    |  | $     | 61,423 |   |  | $ | 32,125  |  
|Cumulative interest sensitivity gap              |  | $                                      | (30,584 | )  |            | $ | (39,260 | )           |  | $ | (29,298       | )  |  | $     | 32,125 |   |  | $ | 32,125  |  
|Ratio of sensitivity gap to total earning assets |  |                                        | (18.0   | )% |            |   | (5.1    | )%          |  |   | (5.9          | )% |  |       | 36.1   | % |  |   | 18.9    | %



---



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, 2003. 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, 2003, the Company appeared to be liability-sensitive with interest-bearing liabilities exceeding earning assets, subject to changes in interest
rates, for the first twelve months. 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 twelve months.



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.



17



---

---



Managements Discussion and Analysis



---



Earnings and Balance Sheet Analysis



2002 Compared to 2001  On a tax-equivalent basis, net interest income for 2002 was $6.8 million, an increase of 5.1% or $329 thousand from 2001. This growth
resulted primarily from the aggregate increase in average loans outstanding, federal funds sold and deposits in other banks, combined with the effect of lower rates paid on deposit accounts when compared to the prior year. Lower overall yields on
interest-earning assets during 2002, however, resulted in the Companys net interest margin declining 4 basis points from the 3.89% achieved for 2001 to 3.85% for 2002. Average interest-earning assets for 2002 increased $10.2 million, or 6.1%.
Average interest-bearing deposits increased $9.1 million for the year 2002 to $141.1 million, an increase of 6.9% over the prior year. Savings deposits increased 43.9%, averaging $29.1 million, and interest checking accounts grew 19.3%, averaging
$12.5 million. The overall rate paid on interest-bearing liabilities for the year 2002 dropped 138 basis points to 3.52%, generating a reduction in total interest expense from the previous year of $1.7 million. The increase in volume of
interest-bearing liabilities offset some of this reduction, netting an overall improvement in interest expense of $1.5 million when compared to 2001.



The Companys investment portfolio decreased by $3.7 million on average to $46.0 million for 2002, mainly due to U.S. Government agency securities being called and
mortgage-backed securities being repaid prior to their scheduled maturity dates due to the continued declining interest rate environment.



In 2002, total loans grew $2.5 million to an average of $108.9 million. An increase in nonfarm and nonresidential loans secured by real estate offset by a decrease in
construction and development loans accounted for the majority of the year-to-year increase in loans.



Total average deposits rose $10.3 million from 2001 to an average of $161.3 million for 2002. Savings deposits accounted for the majority of this increase, growing $7.4 million on average, as depositors shifted funds
from various time deposits and certificates of deposit accounts into savings.



Noninterest income increased $212 thousand in 2002 compared to 2001. Although service charges on deposit accounts and other fees represented the largest component of noninterest income, the Companys investment in bank owned life
insurance during 2002 accounted for the largest portion of the year-to-year increase, contributing $149 thousand to the year-to-year increase. Noninterest expense was $3.8 million for 2002, an increase of $228 thousand over the prior year. Salaries
and benefits, the largest component of noninterest expense represented the majority of this increase. Merit increaeses and higher medical insurance costs were the primary drivers of this increase.



The allowance for loan losses at December 31, 2002 was $1.8 million compared to $1.3 million
a year earlier. The allowance for loan losses as a percentage of period end loans was 1.54% compared to 1.14% at year-end 2001. The Company had recoveries, net of charge-offs, in the amount of $94 thousand for 2002. This compared to net charge-offs
of $276 thousand for 2001. The higher volume of charge-offs in 2001 was related to leasing activities. Nonperforming loans totaled $755 thousand at December 31, 2002, an increase of $50 thousand over 2001s level.



18



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---



Managements Discussion and Analysis



---



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.



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.



19