**SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C.  20549**

 

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**FORM 10-QSB**

 

**(MarkOne)**

 
| **ý**                                                                                                                                                                                              |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                    |   |                                                                                                |   |   |
| **For  the Quarterly Period Ended June 30, 2004**                                                                                                                                                  |
|                                                                                                                                                                                                    |   |                                                                                                |   |   |
| **OR**                                                                                                                                                                                                  |
|                                                                                                                                                                                                    |   |                                                                                                |   |   |
| **o**                                                                                                                                                                                                   |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                    |   |                                                                                                |   |   |
| **For  the Transition Period from                 to               ** |
|                                                                                                                                                                                                    |   |                                                                                                |
| **Commission  file number 0-23181**                                                                                                                                                                |

 

**PAULA FINANCIAL**

(Exact name of small business issuer as specified inits charter)

 
| **Delaware**                                                    |   | **95-4640638**                          |
|-----------------------------------------------------------------|--------|-----------------------------------------|
| (State or other jurisdiction of incorporation or  organization) |   | (I.R.S. Employer identification number) |

 

**PAULAFINANCIAL**

**87East Green Street, Suite 206**

**Pasadena,CA 91105**

(Address of principal executive offices)

 

**(626)844-7100**

(Issuer’s telephone number, including area code)

 

Check whether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

| Yes  ý |   | No  o |
|-----------------------|--------|-----------------|

 

State the number of shares outstanding of each of the issuer’s classesof common equity, as of the latest practicable date.  Number of shares of Common Stock, $.01 par value, outstanding asof close of business on July 31, 2004: 6,198,645 shares.

 

Transitional Small Business Disclosure Format (check one):

| Yes  ý |   | No  o |
|-----------------------|--------|-----------------|

 

 

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PAULA FINANCIAL

INDEX TO FORM 10-Q

 
| PART I. FINANCIAL INFORMATION |                                                                                                                            |
|-------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                            |   |
| Item 1.                       | Financial Statements                                                                                                            |   |
|                          |                                                                                                                            |   |
|                          | Condensed consolidated balance sheets as of  June 30, 2004 (unaudited) and December 31, 2003                          |   |
|                          |                                                                                                                            |   |
|                          | Condensed consolidated statements of income  for the three months and six months ended June 30, 2004 and 2003  (unaudited) |   |
|                          |                                                                                                                            |   |
|                          | Condensed consolidated statements of cash  flows for the six months ended June 30, 2004 and 2003 (unaudited)               |   |
|                          |                                                                                                                            |   |
|                          | Notes to condensed consolidated financial  statements for the three months and six months ended June 30, 2004  (unaudited) |   |
|                          |                                                                                                                            |   |
| Item 2.                       | Management’s Discussion and Analysis of  Consolidated Financial Condition and Results of Operations                        |   |
|                          |                                                                                                                            |   |
| Item 3.                       | Controls and procedures                                                                                                         |   |
|                          |                                                                                                                            |   |
| PART II. OTHER INFORMATION    |                                                                                                                            |
|                          |                                                                                                                            |   |
| Item 4.                       | Submission of Matters to a Vote of Security  Holders                                                                            |   |
|                          |                                                                                                                            |   |
| Item 6.                       | Exhibits and Reports on Form 8-K                                                                                                |   |
|                          |                                                                                                                            |   |
| SIGNATURE                     |                                                                                                                            |

 

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**PART I****                          FINANCIALINFORMATION**

**Item 1.****                                                           FinancialStatements**

 

**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Balance Sheets**

(In thousands, except share data)

 
|                                                                                                                     |   | **June 30,  2004** |     | **December 31,  2003** |     |
|--------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------|-----------------------------|----------|
|                                                                                                                     |   | **(Unaudited)**         |     | **(*)**                     |     |
| ***Assets***                                                                                                             |   |                    |     |                        |     |
| *Current Assets:*                                                                                                        |   |                    | * * |                        | * * |
| Cash (restricted: 2004, $2,751; 2003,  $2,496)                                                                           |   | $                       | 4,390    |                        | $        | 3,110 |   |
| Accounts receivable, net of allowance for  uncollectible accounts (2004 and 2003, $80)                                   |   | 1,336                   |     | 1,829                       |     |
| Commissions receivable                                                                                                   |   | 2,030                   |     | 2,896                       |     |
| Income tax receivable                                                                                                    |   | 9                       |     | —                      |     |
| Other receivables                                                                                                        |   | 28                      |     | 13                          |     |
| Deferred income taxes                                                                                                    |   | 1,180                   |     | 1,662                       |     |
| Other assets                                                                                                             |   | 275                     |     | 372                         |     |
|                                                                                                                     |   | 9,248                   |     | 9,882                       |     |
| *Non-Current Assets:*                                                                                                    |   |                    | * * |                        | * * |
| Property and equipment, net                                                                                              |   | 286                     |     | 246                         |     |
| Investment in related party, at cost                                                                                     |   | 703                     |     | 703                         |     |
| Goodwill, net                                                                                                            |   | 2,017                   |     | 2,069                       |     |
| Other amortizable intangible assets, net                                                                                 |   | 1,867                   |     | 2,159                       |     |
| Deferred income taxes                                                                                                    |   | 4,235                   |     | 4,169                       |     |
| Other assets                                                                                                             |   | 201                     |     | 173                         |     |
|                                                                                                                     |   | $                       | 18,557   |                        | $        | 19,401 |   |
| ***Liabilities and  Stockholders’ Equity***                                                                         |   |                    |     |                        |     |
|                                                                                                                     |   |                    |     |                        |     |
| *Current Liabilities:*                                                                                                   |   |                    |     |                        |     |
| Due to underwriters and assureds                                                                                         |   | $                       | 4,051    |                        | $        | 4,257 |   |
| Accounts payable and accrued expenses                                                                                    |   | 505                     |     | 1,027                       |     |
| Employment related accruals                                                                                              |   | 491                     |     | 645                         |     |
| Acquisition related accruals                                                                                             |   | 1,078                   |     | 993                         |     |
| Income taxes payable                                                                                                     |   | —                  |     | 121                         |     |
| Notes payable to bank                                                                                                    |   | 400                     |     | 400                         |     |
|                                                                                                                     |   | 6,525                   |     | 7,443                       |     |
| *Non-Current Liabilities:*                                                                                               |   |                    |     |                        |     |
| Acquisition related accruals                                                                                             |   | 875                     |     | 1,326                       |     |
| Notes payable to bank                                                                                                    |   | 1,076                   |     | 1,276                       |     |
|                                                                                                                     |   | $                       | 8,476    |                        | $        | 10,045 |   |
| *Stockholders’ Equity:*                                                                                             |   |                    |     |                        |     |
| Preferred stock, $0.01 par value.  Authorized 4,058,823 shares, none issued and outstanding                              |   | $                       | —   |                        | $        | — |   |
| Common stock, $0.01 par value (Authorized  15,000,000 shares, issued: 2004, 7,120,879 shares and 2003, 7,118,379 shares) |   | 71                      |     | 71                          |     |
| Additional paid-in-capital                                                                                               |   | 13,963                  |     | 13,962                      |     |
| Accumulated earnings, after January 1,  2003                                                                        |   | 2,108                   |     | 1,428                       |     |
| Unearned compensation                                                                                                    |   | (96                     | )        | (127                        | )        |
| Employee loans for stock purchase                                                                                        |   | (7                      | )        | (20                         | )        |
| Treasury stock, at cost (2004 and 2003,  924,734 shares)                                                                 |   | (5,958                  | )        | (5,958                      | )        |
|                                                                                                                     |   | $                       | 10,081   |                        | $        | 9,356 |   |
|                                                                                                                     |   | $                       | 18,557   |                        | $        | 19,401 |   |

 

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*  Derived from audited financialstatements.

 

See notes to condensed consolidated financial statements.

 

2

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**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Income**

(In thousands, except share and per sharedata)

 
|                                                     |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                     |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                     |   | **(Unaudited)**                        |   | **(Unaudited)**                      |   |
| ***Income:***                                            |   |                                   |   |                                 |   |   |   |   |   |
| Commissions                                              |   | $                                      | 4,424  |                                 | $      | 4,052 |   | $ | 8,113 |   | $ | 7,522 |   |
| Contingent commissions                                   |   | 19                                     |   | 117                                  |   | 1,297 |   | 1,182 |   |
| Net investment income                                    |   | 1                                      |   | 2                                    |   | 4 |   | 4 |   |
| Service fees                                             |   | 205                                    |   | 83                                   |   | 376 |   | 158 |   |
| Other income                                             |   | 5                                      |   | 45                                   |   | 16 |   | 52 |   |
|                                                     |   | 4,654                                  |   | 4,299                                |   | 9,806 |   | 8,918 |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| ***Operating  Expenses:***                               |   |                                   |   |                                 |   |   |   |   |   |
| Salaries and related expenses                            |   | 2,547                                  |   | 2,456                                |   | 5,221 |   | 4,802 |   |
| Interest expense                                         |   | 19                                     |   | 38                                   |   | 46 |   | 81 |   |
| Amortization expense                                     |   | 148                                    |   | 136                                  |   | 294 |   | 223 |   |
| Other expenses                                           |   | 1,559                                  |   | 1,467                                |   | 3,004 |   | 3,088 |   |
|                                                     |   | 4,273                                  |   | 4,097                                |   | 8,565 |   | 8,194 |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Income from operations before income taxes               |   | 381                                    |   | 202                                  |   | 1,241 |   | 724 |   |
| Income tax expense                                       |   | 166                                    |   | 89                                   |   | 468 |   | 315 |   |
| ***Net income***                                         |   | $                                      | 215    |                                 | $      | 113 |   | $ | 773 |   | $ | 409 |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Earnings per share                                       |   | $                                      | 0.03   |                                 | $      | 0.02 |   | $ | 0.12 |   | $ | 0.07 |   |
| Weighted average shares outstanding                      |   | 6,442,146                              |   | 6,235,264                            |   | 6,441,198 |   | 6,206,398 |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Earnings per share - assuming dilution                   |   | $                                      | 0.03   |                                 | $      | 0.02 |   | $ | 0.11 |   | $ | 0.06 |   |
| Weighted average shares outstanding -  assuming dilution |   | 6,766,115                              |   | 6,476,860                            |   | 6,756,392 |   | 6,418,942 |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Dividends declared per common share                      |   | $                                      | 0.015  |                                 | — |   | $ | 0.015 |   | — |   |

 

See notes to condensed consolidated financial statements.

 

3

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**PAULAFINANCIAL AND SUBSIDIARIES**

**CondensedConsolidated Statements of Cash Flows**

(In thousands)

 
|                                                                                 |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                 |   | **2004**                             |   | **2003** |   |
|                                                                                 |   | **(Unaudited)**                      |   |
| ***Cash flows from  operating activities:***                                         |   |                                 |   |   |   |
| Net income                                                                           |   | $                                    | 773    |   | $ | 409 |   |
|                                                                                 |   |                                 |   |   |   |
| *Adjustments to reconcile net income to net  cash provided by operating activities:* |   |                                 |   |   |   |
| Depreciation and amortization                                                        |   | 360                                  |   | 284 |   |
| (Increase) decrease in receivables                                                   |   | 1,335                                |   | (1,210 | ) |
| Decrease in deferred income taxes                                                    |   | 416                                  |   | 226 |   |
| Increase (decrease) in accounts payable and  accrued expenses                        |   | (1,003                               | )      | 2,683 |   |
| (Increase) decrease in unearned  compensation                                        |   | 31                                   |   | (17 | ) |
| Other, net                                                                           |   | 68                                   |   | 19 |   |
| ***Net cash provided  by operating activities***                                     |   | 1,980                                |   | 2,394 |   |
|                                                                                 |   |                                 |   |   |   |
| ***Cash flows from  investing activities:***                                         |   |                                 |   |   |   |
| Purchase of property and equipment                                                   |   | (106                                 | )      | (41 | ) |
| Purchase of book of business                                                         |   | (314                                 | )      | (247 | ) |
| ***Net cash used in  investing activities***                                         |   | (420                                 | )      | (288 | ) |
|                                                                                 |   |                                 |   |   |   |
| ***Cash flows from  financing activities:***                                         |   |                                 |   |   |   |
| Payments on note payable to bank                                                     |   | —                               |   | (650 | ) |
| Payments on line of credit                                                           |   | (200                                 | )      | — |   |
| Dividends paid                                                                       |   | (93                                  | )      | — |   |
| Repayment of employee loans for stock  purchase                                      |   | 13                                   |   | 35 |   |
| ***Net cash used in  financing activities***                                         |   | (280                                 | )      | (615 | ) |
|                                                                                 |   |                                 |   |   |   |
| ***Net increase in  cash and invested cash***                                        |   | 1,280                                |   | 1,491 |   |
| Cash and invested cash at beginning of  period                                       |   | 3,110                                |   | 1,290 |   |
| ***Cash and invested  cash at end of period***                                       |   | 4,390                                |   | $ | 2,781 |   |
|                                                                                      |        |                                      |        |  |  |  |  |

 

See notes to condensed consolidated financial statements.

 

4

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**PAULAFINANCIAL AND SUBSIDIARIES**

**Notesto Condensed Consolidated Financial Statements**

**Forthe Three Months and Six Months Ended June 30, 2004 (Unaudited)**

 

**Note A - Basis ofPresentation**

 

PAULA Financial and subsidiaries (the “Company”) is a California-basedspecialty distributor of commercial insurance products.  The Company’s agency operations place a fullarray of commercial insurance products for their customers.  In addition, the Company owns a third partyadministration operation which has minimal operations.

 

The accompanying unaudited condensed consolidated financial statementsof the Company have been prepared in accordance with accounting principlesgenerally accepted in the United States (“GAAP”) for interim financialinformation and with the instructions to Form 10-QSB and Article 10 ofRegulation S-X.  Accordingly, they donot include all of the information and footnotes required by GAAP for completefinancial statements.  In the opinion ofmanagement, all adjustments, including normally occurring accruals, considerednecessary for a fair presentation have been included.

 

The Company’s operating results tend to be cyclical. Consequently,operating results for the six months ended June 30, 2004 are notnecessarily indicative of the results to be expected for the yearDecember 31, 2004.  For furtherinformation, refer to the consolidated financial statements and footnotesthereto included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

In December 2002, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standard (“SFAS”) No. 148, “Accounting forStock Based Compensation – Transition and Disclosure, an amendment of SFAS 123”.  Among other provisions, SFAS 148 amends thedisclosure requirements of SFAS 123 to require prominent disclosures in bothannual and interim financial statements. For the six months ended June 30, 2004, the differences between theas reported net income and income per share amounts and the related pro formaamounts are not material to the consolidated financial statements.

 

**Note B –Comprehensive Income**

 

The Company has not included a statement of comprehensive income in theaccompanying consolidated financial statements as the Company does not have anyother comprehensive income adjustments.

 

5

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**Note C – DeferredIncome Taxes**

 

As of June 30, 2004 and December 31, 2003, the Company’s netdeferred tax asset is comprised of the following:

 
|                             |   | **June 30  2004** |   | **Dec 31  2003** |   |
|----------------------------------|--------|------------------------|--------|------------------|--------|
|                             |   | **(unaudited)**        |   |             |   |
| Deferred tax assets:             |   |                   |   |             |   |
| Net operating loss carry forward |   | $                      | 25,358 |             | $      | 25,222 |   |
| Other                            |   | 2,703                  |   | 3,255            |   |
| Gross deferred tax assets        |   | 28,061                 |   | 28,477           |   |
| Less valuation allowance         |   | (22,646                | )      | (22,646          | )      |
| Deferred tax assets              |   | $                      | 5,415  |             | $      | 5,831 |   |
| Gross deferred tax liabilities   |   | $                      | — |             | $      | — |   |
| Net deferred tax asset           |   | $                      | 5,415  |             | $      | 5,831 |   |

 

The net operating loss carry forward includes losses generated by PAULAInsurance Company which are available to offset future taxable income of theCompany.

 

Management believes that it is more likely than not that the results offuture operations will generate sufficient taxable income in the periodsnecessary to realize the net deferred tax asset.

 

**Note D – OtherMatters**

 

In early 1999,PAULA Financial made an investment in a start up specialty workers’compensation insurance company, Montlake Insurance Holdings, LLC(“Montlake”).  This investment wasaccounted for using the equity method. During the initial set up of the Montlake operations, PAULA Financialprovided assistance in several areas including license application, insuranceplacement, human resource matters and systems support.  As part of this support, PAULA Financialexecuted a guarantee related to certain aspects of the relationship betweenMontlake and the issuing company, Reliance Insurance Company (“Reliance”).  At the time of the guarantee, Reliance didnot retain any exposure associated with the premiums fronted.   Reliance was the issuing carrier forMontlake from March 15, 1999 to July 31, 2000.

 

InOctober 2001, Reliance was placed in liquidation by the PennsylvaniaDepartment of Insurance.  InOctober 2002, Montlake was liquidated by the Superior Court of Washingtonfor King County.

 

In May 2004, theCompany received a demand for payment from Reliance in Liquidation in theamount of $1.9 million related to unpaid deductibles by a policyholder placedunder the Montlake fronting arrangement with Reliance.  The policy in question was effectiveMarch 2000 and was cancelled in September 2000.

 

While the Companyis still in the early stages of its investigation into the matter, it believesthat there are good and meritorious arguments that the demand does notrepresent an obligation of the Company. The Company believes that the obligations subject to the guarantee werepreviously discharged.

 

6

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**PART I****                                                       FINANCIALINFORMATION**

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

** **

**Overview**

 

The Company’srevenues consist of agency commission income, contingent commission income, andservice fees. Commission income is earned from Pan American Underwriters’ (“PanAm’s”) insurance sales activity. Associated premiums are primarily billed directly by the insurancecarrier.  However, in certain instances,Pan Am will invoice the customer and remit the premium, less commission, to theinsurance carrier.  The Company focusesits sales efforts on agribusiness and rural markets in California andArizona.  Contingent commission isrelated to volume and profit sharing arrangements with insurance carriers.  Service fees are primarily received for theperformance of services related to loss control and claims advocacy.

 

The Company’s expenses consist of salaries and related expenses,interest expense, amortization of intangibles and other general andadministrative expenses.

 

**Results of Operationsfor the Three Months and Six Months Ended June 30, 2004 Compared to theThree Months and Six Months Ended June 30, 2003:**

 

**Commission income.**For the three months ended June 30, 2004 commission income increased 9.2%to $4.4 million compared to $4.1 million for the comparable 2003 period.  For the six months ended June 30, 2004commission income increased 7.9% to $8.1 million compared to $7.5 million forthe comparable 2003 period.  For thepast several quarters the Company has experienced significant commission growthover prior periods due to the integration of acquisitions initiated in mid-2002and early 2003.  As of the first quarterof 2004, these acquisitions were fully internalized.  As anticipated, these acquisitions and their associated revenuediversification have more than offset the market softening we are nowexperiencing in certain segments of the marketplace.  Also contributing to the increase in commissions in the firsthalf of 2004 is an increase in commissions associated with the placement ofvarious property and casualty lines of business.

 

**Contingent commissionincome.** For the three months ended June 30, 2004contingent commission income decreased 83.8% to $19,000 compared to $117,000for the comparable 2003 period.  For thesix months ended June 30, 2004 contingent commission income increased 9.7%to $1.3 million compared to $1.2 million for the comparable 2003 period.  Contingent commission fluctuates from yearto year based on the profitability of the underlying business and externalmarket conditions which can result in changes to contingency programs offeredby insurance carriers.  In the firsthalf of 2004, approximately 40% of the contingent commission income earnedrelated to contingency revenue received from the California State CompensationInsurance Fund (“SCIF”) related to the 2003 policy year.  In total for the 2003 policy year, theCompany earned contingent revenue on the SCIF business totaling $1.5 millionwhich was comprised of three components: volume bonuses, retention bonuses and profit sharing.  In 2004, SCIF has discontinued contingentcommission arrangements associated with volume and retention bonuses butretained the profit sharing component. Therefore, contingent commission revenue for the 2004 policy yearrelated to SCIF business is expected to decline.

 

7

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**Service fees.**  Service fee income increased to $205,000 forthe three months ended June 30, 2004 from $83,000 for the comparable 2003period.  For the six months endedJune 30, 2004 service fee income increased to $376,000 from $158,000 forthe comparable 2003 period.  Theincrease in service fees is due to new service arrangements where the Companyis paid for providing loss control and other field support services to selectedaccounts.  Pan Am provides loss controland other services both as a contractor to selected insurance carriers and on adirect basis to its customers.

 

**Salaries and relatedexpenses.** Salaries and employee benefits increased 3.7% to $2.5 million for thethree months ended June 30, 2004 from $2.4 million for the comparable 2003period.  For the six months endedJune 30, 2004 salaries and employee benefits increased 8.7% to $5.2million from $4.8 million for the comparable 2003 period.  The increase is largely due to therecruitment of senior leadership in early 2004 related to further developingthe service fee platform. The costs associated with this investment in newsenior leadership is partially being offset by salary restructurings at themost senior levels of the Company. Under the new program, variable compensationis tied to compounded earnings growth with baseline targets in excess of theCompany’s current organic capacity. Salaries and related expenses was 53% of total revenues for the firsthalf of 2004 and 54% for the first half of 2003.

 

**Interest expense.**  Interest expense decreased 50.0% to $19,000for the three months ended June 30, 2004 from $38,000 for the comparable2003 period.  For the six months endedJune 30, 2004 interest expense decreased 43.2% to $46,000 from $81,000 forthe comparable 2003 period.  Thedecrease is due to the decline in the outstanding balance of the related notepayable.

 

**Amortization expense.**  Amortization expense increased 8.8% to$148,000 for the three months ended June 30, 2004 from $136,000 for thecomparable 2003 period.  For the sixmonths ended June 30, 2004 amortization expense increased 31.8% to$294,000 from $223,000 for the comparable 2003 period.  The increase is due to an increase inamortizable intangible assets related to acquisitions in mid 2002 and early2003.

 

**Other expenses.**  Other expenses increased 6.3% to $1.6million for the three months ended June 30, 2004 from $1.5 million for thecomparable 2003 period.   For the sixmonths ended June 30, 2004 other expenses decreased 2.7% to $3.0 millionfrom $3.1 million for the comparable 2003 period.

 

**Income taxes oncontinuing operations.**  Income tax expense for the three months ended June 30, 2004was $166,000 compared to $89,000 for the comparable 2003 period.  Income tax expense for the six months endedJune 30, 2004 was $468,000 compared to $315,000 for the comparable 2003period.  The effective combined incometax rates for the six months ended June 30, 2004 and 2003 were 37.7% and43.5%, respectively.  The differencesbetween the applicable Federal tax rate and the effective tax rates is due tothe impact of state taxes.

 

**Net income.**  Net income increased 90.3% to $215,000 forthe three months ended June 30, 2004 from $113,000 for the comparable 2003period.  Net income increased 89.0% to$773,000 for the six months ended June 30, 2004 from $409,000 for thecomparable 2003 period.  The increase isdue to the factors discussed above.

 

8

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**Liquidity and CapitalResources:**

 

As a holding company, PAULA Financial’s principal sources of funds aredividends and expense reimbursements from its operating subsidiaries andproceeds from the sale of its capital stock. PAULA Financial’s principal usesof funds are capital contributions to its subsidiaries, payment of operatingexpenses, dividends to shareholders and repurchase of Company common stock.

 

On November 1, 2003, the Company refinanced its outstanding bankdebt with a $1,800,000 reducing revolving line of credit (the “Line of Credit”)with US Bank (the “Lender”).  The Lineof Credit matures one year from funding, with a one-year automatic option toextend as long as the Company is in compliance with all covenants.  As of June 30, 2004, PAULA Financialwas in compliance with all of the covenants. Balances outstanding under the Line of Credit bear interest at the primerate plus 1.0%.  As of July, 2004, theinterest rate was 5.25%.  PAULAFinancial’s subsidiaries have guaranteed the obligations of PAULA Financialunder the Line of Credit.  Additionally,the Lender has a security interest in the assets of the Company.

 

The Company’s Board of Directors had previously approved a 1,000,000share repurchase program.  OnFebruary 20, 2003, the Board of Directors authorized an additional2,000,000 shares for the share repurchase program.  As of June 30, 2004, the Company held 924,734 shares intreasury stock.

 

On May 28, 2004, The Company announced the reinstatement of a quarterlycash dividend in the amount of $0.015 per common share.  The dividend was paid to holders of recordas of June 8, 2004 and was distributed on June 28, 2004.

 

**Off-Balance SheetArrangements**

 

The Company does not have any off-balance sheet arrangements.

 

**Forward-LookingStatements**

 

In connection with, and because it desires to take advantage of the“safe harbor” provisions of the Private Securities Litigation Reform Act of1995, the Company cautions readers to recognize the existence of certainforward-looking statements in this Form 10-Q and in any other statement madeby, or on behalf of, the Company, whether or not in future filings with theSecurities and Exchange Commission. Forward-looking statements are statements not based on historicalinformation and which relate to future operations, strategies, financialresults or other developments.  Someforward-looking statements may be identified by the use of terms such as“expects,” “believes,” “anticipates,” “intends,” or “judgment.” Forward-lookingstatements are necessarily based upon estimates and assumptions that areinherently subject to significant business, economic and competitiveuncertainties, many of which are beyond the Company’s control and many ofwhich, with respect to future business decisions, are subject to change.  Examples of such uncertainties andcontingencies include, among other important factors, those affecting theinsurance industry in general, such as the economic and interest rateenvironment, legislative and regulatory developments and market pricing andcompetitive trends, and those relating specifically to the Company and itsbusinesses, such as the level of commission revenue and fee income, andacquisitions of companies or blocks of business.  These uncertainties and contingencies can affect actual resultsand could cause actual results to differ materially from those expressed in anyforward-looking statements made by, or on behalf of, the Company. The Companydisclaims any obligation to update forward-looking statements.

 

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**PART I****                                                       FINANCIALINFORMATION**

 

**Item 3: Controls and Procedures**

 

**Evaluation ofDisclosure Controls and Procedures**

 

The Company’s Chief Executive Officer and Vice President Finance haveevaluated the effectiveness of the Company’s disclosure controls and procedures(as defined in Rules 13a – 15(e) and 15d – 15(e) under the Securities ExchangeAct of 1934) as of the end of the period covered by this quarterly report.  Based on this evaluation, such officers haveconcluded that the Company’s disclosure controls and procedures as of the endof the period covered by this quarterly report were effective for ensuring thatinformation required to be disclosed in the reports it files or submits underthe Exchange Act is recorded, processed, summarized and reported in a timelymanner.  There have not been any significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect such controls.

 

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**PART II.  OTHER INFORMATION**

 

**Item4:  Submission of Matters to a Vote ofSecurity Holders**

 

The Company heldits 2004 Annual Meeting of Stockholders on Wednesday, May 26, 2004 for thepurpose of voting on a proposal to increase the aggregate number of sharesreserved for issuance under the Company’s Amended and Restated 1997 Stock IncentivePlan (“the 1997 Plan”) from 900,000 shares to 1,500,000 shares and to increasethe limit on the number of shares subject to awards that may be granted in anycalendar year to any one employee to 700,000 shares.  At the meeting, the proposal was approved.

 

The followingtable indicates the number of shares voted on the proposal:

 
|    |   | **Shares  Voted** |   |
|---------|--------|-------------------|--------|
| For     |   | 3,130,919         |   |
| Against |   | 202,002           |   |
| Abstain |   | 23,360            |   |

 

**Item 6:  Exhibits and Reports on Form 8-K:**

 

(a)          Exhibits.

 

11.         Computation of EarningsPer Share.

 

31.1   Rule 13a -14a /15d -14aCertification of Chief Executive Officer.

 

31.2   Rule 13a -14a /15d -14aCertification of Chief Financial Officer.

 

32.1   Section 1350Certifications of Chief Executive Officer.

 

32.2   Section 1350Certifications of Chief Financial Officer.

 

(b)Reports on Form 8-K.

 

On May 19, 2004, the Company filed a Form 8-Krelated to the press release announcing operating results for the quarter endedMarch 31, 2004.

 

On June 1, 2004, the Company filed a Form 8-Krelated to the press release announcing a cash dividend declaration.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange, the Registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| Date:  August 13, 2004 |                     | PAULA  FINANCIAL        |
|----------------------------------|--------------------------|-------------------------|
|                             |                     |                    |
|                             |                     |                    |
|                             | By:                      | /s/ Deborah S. Maddocks |   |
|                             | Vice President - Finance |

 

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