**Exhibit13.1**

**To Our Stockholders,**

 

2001 was a year of strong performance for your company, despite adifficult business environment.  Weincreased sales volume to record levels by providing the high quality servicewhich is our hallmark.  Our net incomealso grew, particularly in the second half of the year.  HPSC is positioned to continue to bean important force in small-ticket medical equipment financing.

 

HPSC is a direct beneficiary of a major demographic change occurring inthe United States today. The aging of the population and the movement of the 70million-strong “baby boomer” cohort through middle age and into the ranks of“senior citizens” has led to two important developments in the healthcareindustry.  First, this population now *needs*more healthcare services as its’ members age. Second, members of this group are increasingly sophisticated consumersof healthcare services with a strong interest in receiving more services andhaving access to the best and most recent technology.  These trends are leading our customers — independent healthcarepractitioners in a variety of specialties across the country — to increase theacquisition of medical equipment for which we provide financing.  HPSC has established relationships with morethan 1,000 vendors of a wide variety of medical equipment, and our nationalsales network now operates in all 50 states, enabling us to serve effectivelymore healthcare practitioners.

 

For the full year 2001, our net revenues increased 2% to $53.5 millionfrom $52.3 million in 2000.  Net incomein 2001 was $3.2 million or $0.74 per share on a diluted basis, with the fourthquarter results particularly encouraging. Origination volume increased from $249 million in 2000 to $263 millionin 2001, a 6% rise, and the gross owned and managed receivables, an importantmeasurement of our continuing growth, rose from $696 million at the end of 2000to $807 million as of December 31, 2001, a 16% climb.  These results were built on the foundation we created at the endof 2000 with our $527 million term securitization, which provided the Companywith lower-cost funding.  This keytransaction provided us with the capability to offer more competitive productsat higher profitability during 2001.

 

Independent healthcare practitioners — dentists, primary care doctors,ophthalmologists, veterinarians, chiropractors or other specialists — are alarge and important segment of the healthcare industry.  During 2002, HPSC will continue to sharpenits focus on the independent healthcare practitioner financing market where webelieve we have a strong competitive advantage.  Our commitment to personal service and quick response to ourcustomers’ needs allows us to compete aggressively and successfully against muchlarger companies.  We believe that overtime this dedication will make us the premier financing company in thesmall-ticket medical equipment sector and provide increasing financial returnsto our investors.

 

Joseph A. Biernat, who served as a Director of HPSC, Inc sinceDecember, 1993, retired at our Annual Meeting in 2001.  Joe was an important contributor to ourboard, providing us with essential advice and insight at critical times in ourcompany’s development.  All of ourshareholders benefited from his wisdom, and I thank him on behalf of our entirecompany for his many years of significant service on our board.

 

In December, 2001, Gunnar Overstrom died.   He was a Director of our board and former vice-chairman of FleetBank; and in addition to Gunnar’s extraordinary business accomplishments andhis concern for others around him, he brought to our board many years ofexperience and integrity.  He will bemissed by all of us.

 

As always, we are grateful for the continuing support of our loyalemployees, business associates and shareholders.

 
| **Sincerely,**                            |
|-------------------------------------------|
|                                      |
|                                      |
| **John W. Everets,**                      |
| **Chairman and Chief Executive  Officer** |

 

 

----

 

**HPSC, Inc. and Subsidiaries**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                       |   | **December 31,**                                        |    |
|----------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------|---------|
|                                                                                                                       |   | **2001**                                                |    | **2000** |   |
|                                                                                                                       |   | **(in thousands, except per share  and share amounts)** |    |
| **ASSETS**                                                                                                                 |   |                                                    |    |   |   |
| Cash and cash equivalents                                                                                                  |   | $                                                       | 4,510   |   | $ | 1,713 |   |
| Restricted cash- Servicing under securitization agreements                                                                 |   | 29,471                                                  |    | 20,284 |   |
| Restricted cash- Prefunding                                                                                                |   | —                                                  |    | 95,218 |   |
| Investment in leases and notes:                                                                                            |   |                                                    |    |   |   |
| Lease contracts and notes receivable due in installments                                                                   |   | 428,463                                                 |    | 404,366 |   |
| Notes receivable                                                                                                           |   | 35,002                                                  |    | 37,686 |   |
| Retained interest in leases and notes sold                                                                                 |   | 25,780                                                  |    | 13,690 |   |
| Estimated residual value of equipment at end of lease term                                                                 |   | 24,113                                                  |    | 22,121 |   |
| Deferred origination costs                                                                                                 |   | 9,658                                                   |    | 9,061 |   |
| Less: Unearned income                                                                                                      |   | (104,741                                                | )       | (98,089 | ) |
| Security deposits                                                                                                          |   | (5,051                                                  | )       | (5,893 | ) |
| Allowance for losses                                                                                                       |   | (15,359                                                 | )       | (14,170 | ) |
| Total net investment in leases and notes                                                                                   |   | 397,865                                                 |    | 368,772 |   |
|                                                                                                                       |   |                                                    |    |   |   |
| Other assets                                                                                                               |   | 9,893                                                   |    | 10,376 |   |
| Total Assets                                                                                                               |   | $                                                       | 441,739 |   | $ | 496,363 |   |
|                                                                                                                       |   |                                                    |    |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                             |   |                                                    |    |   |   |
| Revolving credit borrowings                                                                                                |   | $                                                       | 52,000  |   | $ | 49,000 |   |
| Senior notes, net of discount                                                                                              |   | 284,806                                                 |    | 355,461 |   |
| Subordinated debt                                                                                                          |   | 19,985                                                  |    | 19,985 |   |
| Accounts payable and accrued liabilities                                                                                   |   | 27,224                                                  |    | 18,932 |   |
| Accrued interest                                                                                                           |   | 1,659                                                   |    | 2,210 |   |
| Interest rate swap contracts                                                                                               |   | 7,230                                                   |    | — |   |
| Deferred income taxes                                                                                                      |   | 9,179                                                   |    | 9,985 |   |
| Total Liabilities                                                                                                          |   | 402,083                                                 |    | 455,573 |   |
|                                                                                                                       |   |                                                    |    |   |   |
| Commitments and Contingencies   (Note F)                                                                              |   |                                                    |    |   |   |
|                                                                                                                       |   |                                                    |    |   |   |
| Stockholders’  Equity:                                                                                           |   |                                                    |    |   |   |
| Preferred stock, $1.00 par value; authorized, 5,000,000 shares;  issued, none                                              |   | —                                                  |    | — |   |
| Common stock, $.01 par value; 15,000,000 shares authorized; issued,  4,779,530 shares in 2001 and 4,713,030 shares in 2000 |   | 48                                                      |    | 47 |   |
| Additional paid-in capital                                                                                                 |   | 14,867                                                  |    | 14,364 |   |
| Retained earnings                                                                                                          |   | 34,470                                                  |    | 31,254 |   |
|                                                                                                                       |   |                                                    |    |   |   |
| Less: Treasury stock, at cost;   615,765 shares in 2001 and 546,477 shares in 2000                                    |   | (4,325                                                  | )       | (3,830 | ) |
| Accumulated  other comprehensive loss, net of tax                                                                          |   | (4,348                                                  | )       | — |   |
| Deferred  compensation                                                                                                     |   | (305                                                    | )       | (635 | ) |
| Notes  receivable from officers and employees                                                                              |   | (751                                                    | )       | (410 | ) |
| Total Stockholders’ Equity                                                                                            |   | 39,656                                                  |    | 40,790 |   |
| Total Liabilities and Stockholders’ Equity                                                                            |   | $                                                       | 441,739 |   | $ | 496,363 |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

2

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**HPSC, Inc. and Subsidiaries**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
|                                                |   | **Year Ended December 31,**                             |   |
|-----------------------------------------------------|--------|---------------------------------------------------------|--------|
|                                                |   | **2001**                                                |   | **2000** |   | **1999** |   |
|                                                |   | **(in  thousands, except per share and share amounts)** |   |
| Revenues:                                           |   |                                                    |   |   |   |   |   |
| Earned income on leases and notes                   |   | $                                                       | 47,970 |   | $ | 49,462 |   | $ | 40,551 |   |
| Gain on sales of leases and notes                   |   | 14,928                                                  |   | 12,078 |   | 4,916 |   |
| Provision for losses                                |   | (9,409                                                  | )      | (9,218 | ) | (4,489 | ) |
| Net Revenues                                        |   | 53,489                                                  |   | 52,322 |   | 40,978 |   |
|                                                |   |                                                    |   |   |   |   |   |
| Operating and Other (Income) Expenses:              |   |                                                    |   |   |   |   |   |
| Selling, general and administrative                 |   | 22,126                                                  |   | 19,781 |   | 17,715 |   |
| Term securitization costs                           |   | —                                                  |   | 7,106 |   | — |   |
| Interest expense                                    |   | 27,872                                                  |   | 26,222 |   | 18,903 |   |
| Interest income                                     |   | (1,879                                                  | )      | (1,018 | ) | (266 | ) |
|                                                |   |                                                    |   |   |   |   |   |
| Income before Income Taxes                          |   | 5,370                                                   |   | 231 |   | 4,626 |   |
| Provision for Income Taxes                          |   | 2,154                                                   |   | 144 |   | 1,907 |   |
| Net Income                                          |   | $                                                       | 3,216  |   | $ | 87 |   | $ | 2,719 |   |
|                                                |   |                                                    |   |   |   |   |   |
| Basic Net Income per Share                          |   | $                                                       | 0.81   |   | $ | 0.02 |   | $ | 0.72 |   |
|                                                |   |                                                    |   |   |   |   |   |
| Shares Used to Compute Basic Net Income per Share   |   | 3,965,378                                               |   | 3,879,496 |   | 3,766,684 |   |
|                                                |   |                                                    |   |   |   |   |   |
| Diluted Net Income per Share                        |   | $                                                       | 0.74   |   | $ | 0.02 |   | $ | 0.61 |   |
|                                                |   |                                                    |   |   |   |   |   |
| Shares Used to Compute Diluted Net Income per Share |   | 4,319,673                                               |   | 4,292,650 |   | 4,436,476 |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

3

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**HPSC, Inc. and Subsidiaries**

**CONSOLIDATED STATEMENTS  OF  CHANGES IN  STOCKHOLDERS’  EQUITY AND**

**COMPREHENSIVEINCOME**

** **
|                                                                                   |   |       |   | **Additional Paid-In****** |   | **Retained******                          |   | **Treasury** |   | **Accumulated Other Comprehen-  sive Loss****,** |   | **Deferred**   |   | **Notes  Receivable  from  Officers and** |   | **Total Stockholders** |   |
|----------------------------------------------------------------------------------------|--------|------------|--------|----------------------------|--------|-------------------------------------------|--------|--------------|--------|--------------------------------------------------|--------|----------------|--------|-------------------------------------------|--------|------------------------|--------|
| **Common Stock**                                                                       |
|                                                                                   |   | **Shares** |   | **Amount**                 |   | **Capital**                               |   | **Earnings** |   | **Stock**                                        |   | **net of tax** |   | **Compensation**                          |   | **Employees**          |   | **Equity** |   |
|                                                                                   |   |       |   |                       |   | **(in thousands, except share  amounts)** |   |         |   |                                             |   |
| Balance at January 1, 1999                                                             |   | 4,618,530  |   | $                          | 46     |                                      | $      | 12,941       |   | $                                                | 28,448 |           | $      | (2,230                                    | )      | $                      | — |   | $ | (1,141 | ) | $ | (489 | ) | $ | 37,575 |   |
|                                                                                   |   |       |   |                       |   |                                      |   |         |   |                                             |   |           |   |                                      |   |                   |   |   |   |
| Net Income                                                                             |   | —     |   | —                     |   | —                                    |   | 2,719        |   | —                                           |   | —         |   | —                                    |   | —                 |   | 2,719 |   |
| Restricted Stock Awards                                                                |   | —     |   | —                     |   | 637                                       |   | —       |   | —                                           |   | —         |   | (637                                      | )      | —                 |   | — |   |
| Restricted Stock Forfeitures                                                           |   | (2,000     | )      | —                     |   | (18                                       | )      | —       |   | —                                           |   | —         |   | 18                                        |   | —                 |   |   |   |
| Purchase of Treasury Stock                                                             |   | —     |   | —                     |   | —                                    |   | —       |   | (1,381                                           | )      | —         |   | —                                    |   | —                 |   | (1,381 | ) |
| Restricted Stock Compensation                                                          |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | 647                                       |   | —                 |   | 647 |   |
| ESOP Compensation                                                                      |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | 105                                       |   | —                 |   | 105 |   |
| Notes Receivable from Officers and Employees                                           |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | —                                    |   | 93                     |   | 93 |   |
| Stock Bonus Awards                                                                     |   | 6,000      |   | —                     |   | 53                                        |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 53 |   |
| Exercise of Stock Options                                                              |   | 77,000     |   | 1                          |   | 299                                       |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 300 |   |
| Tax Benefit related to Exercise of Non-Qualified Stock Options                         |   | —     |   | —                     |   | 139                                       |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 139 |   |
| Extension of Stock Options Scheduled to Expire                                         |   | —     |   | —                     |   | 68                                        |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 68 |   |
| Balance at December 31, 1999                                                           |   | 4,699,530  |   | 47                         |   | 14,119                                    |   | 31,167       |   | (3,611                                           | )      | —         |   | (1,008                                    | )      | (396                   | )      | 40,318 |   |
|                                                                                   |   |       |   |                       |   |                                      |   |         |   |                                             |   |           |   |                                      |   |                   |   |   |   |
| Net Income                                                                             |   | —     |   | —                     |   | —                                    |   | 87           |   | —                                           |   | —         |   | —                                    |   | —                 |   | 87 |   |
| Purchase of Treasury Stock                                                             |   | —     |   | —                     |   | —                                    |   | —       |   | (219                                             | )      | —         |   | —                                    |   | —                 |   | (219 | ) |
| Restricted Stock Compensation                                                          |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | 268                                       |   | —                 |   | 268 |   |
| ESOP Compensation                                                                      |   | —     |   | —                     |   | 157                                       |   | —       |   | —                                           |   | —         |   | 105                                       |   | —                 |   | 262 |   |
| Notes Receivable from Officers and Employees                                           |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | —                                    |   | (14                    | )      | (14 | ) |
| Stock Bonus Awards                                                                     |   | 7,000      |   | —                     |   | 52                                        |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 52 |   |
| Exercise of Stock Options                                                              |   | 6,500      |   | —                     |   | 27                                        |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 27 |   |
| Tax Benefit related to Exercise of Non-Qualified Stock Options                         |   | —     |   | —                     |   | 9                                         |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 9 |   |
| Balance at December 31, 2000                                                           |   | 4,713,030  |   | 47                         |   | 14,364                                    |   | 31,254       |   | (3,830                                           | )      | —         |   | (635                                      | )      | (410                   | )      | 40,790 |   |
|                                                                                   |   |       |   |                       |   |                                      |   |         |   |                                             |   |           |   |                                      |   |                   |   |   |   |
| Net Income                                                                             |   | —     |   | —                     |   | —                                    |   | 3,216        |   | —                                           |   | —         |   | —                                    |   | —                 |   | 3,216 |   |
| Net unrealized gain on foreign currency translation (net of deferred  taxes of $24)    |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | 36             |   | —                                    |   | —                 |   | 36 |   |
| Net unrealized loss on interest rate swap contracts (net of deferred  taxes of $2,837) |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | (4,384         | )      | —                                    |   | —                 |   | (4,384 | ) |
| Total Comprehensive loss                                                               |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | (1,132 | ) |
|                                                                                   |   |       |   |                       |   |                                      |   |         |   |                                             |   |           |   |                                      |   |                   |   |   |   |
| Purchase of Treasury Stock                                                             |   | —     |   | —                     |   | —                                    |   | —       |   | (495                                             | )      | —         |   | —                                    |   | —                 |   | (495 | ) |
| Restricted Stock Compensation                                                          |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | 225                                       |   | —                 |   | 225 |   |
| ESOP Compensation                                                                      |   | —     |   | —                     |   | 130                                       |   | —       |   | —                                           |   | —         |   | 105                                       |   | —                 |   | 235 |   |
| Notes Receivable from Officers and Employees                                           |   | —     |   | —                     |   | —                                    |   | —       |   | —                                           |   | —         |   | —                                    |   | (341                   | )      | (341 | ) |
| Stock Bonus Awards                                                                     |   | 6,000      |   | —                     |   | 48                                        |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 48 |   |
| Exercise of Stock Options                                                              |   | 60,500     |   | 1                          |   | 234                                       |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 235 |   |
| Tax Benefit related to Exercise of Non-Qualified Stock Options                         |   | —     |   | —                     |   | 91                                        |   | —       |   | —                                           |   | —         |   | —                                    |   | —                 |   | 91 |   |
| Balance at December 31, 2001                                                           |   | 4,779,530  |   | $                          | 48     |                                      | $      | 14,867       |   | $                                                | 34,470 |           | $      | (4,325                                    | )      | $                      | (4,348 | ) | $ | (305 | ) | $ | (751 | ) | $ | 39,656 |   |
|                                                                                        |        |            |        |                            |        |                                           |        |              |        |                                                  |        |                |        |                                           |        |                        |        |  |  |  |  |  |  |  |  |  |  |  |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

4

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**HPSC, Inc. and Subsidiaries**

**CONSOLIDATED STATEMENTS  OF  CASH FLOWS**

 
|                                                                                                                                      |   | **Year Ended December 31,** |    |
|-------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                                      |   | **2001**                    |    | **2000** |   | **1999** |   |
|                                                                                                                                      |   | **(in thousands)**          |    |
| **Cash Flows from Operating Activities**                                                                                                  |   |                        |    |   |   |   |   |
| Net income                                                                                                                                |   | $                           | 3,216   |   | $ | 87 |   | $ | 2,719 |   |
| Adjustments to reconcile net income to cash provided by operating  activities:                                                            |   |                        |    |   |   |   |   |
| Depreciation and amortization                                                                                                             |   | 7,210                       |    | 6,033 |   | 5,204 |   |
| Increase (decrease) in deferred income taxes                                                                                              |   | 2,067                       |    | (207 | ) | 1,096 |   |
| Restricted stock, stock option, and stock bonus award compensation                                                                        |   | 615                         |    | 604 |   | 768 |   |
| Gain on sale of lease contracts and notes receivable                                                                                      |   | (14,928                     | )       | (12,078 | ) | (4,916 | ) |
| Interest rate swap breakage cost                                                                                                          |   | 636                         |    | 3,988 |   | — |   |
| Structural costs and retained interest impairment upon transfer of  assets from CP conduits to term securitization                        |   | —                      |    | 3,118 |   | — |   |
| Provision for losses on lease contracts and notes receivable                                                                              |   | 9,409                       |    | 9,218 |   | 4,489 |   |
| Increase (decrease) in accrued interest                                                                                                   |   | (551                        | )       | 270 |   | 655 |   |
| Increase (decrease) in accounts payable and accrued liabilities                                                                           |   | 2,014                       |    | (1,060 | ) | 2,068 |   |
| Increase (decrease) in accrued income taxes                                                                                               |   | 13                          |    | (120 | ) | 314 |   |
| Decrease in refundable income taxes                                                                                                       |   | —                      |    | 260 |   | 514 |   |
| (Increase) decrease in other assets                                                                                                       |   | (1,103                      | )       | (2,038 | ) | (2,158 | ) |
| Cash provided by operating activities                                                                                                     |   | 8,598                       |    | 8,075 |   | 10,753 |   |
|                                                                                                                                      |   |                        |    |   |   |   |   |
| **Cash Flows from Investing Activities**                                                                                                  |   |                        |    |   |   |   |   |
| Origination of lease contracts and notes receivable due in  installments                                                                  |   | (258,782                    | )       | (251,206 | ) | (209,653 | ) |
| Portfolio receipts, net of amounts included in income                                                                                     |   | 79,115                      |    | 89,402 |   | 77,309 |   |
| Proceeds from sales of lease contracts and notes receivable due in  installments                                                          |   | 26,145                      |    | 50,818 |   | 54,390 |   |
| Net proceeds received from term securitization from reacquisition and  resale of lease contracts and notes receivable due in installments |   | —                      |    | 9,804 |   | — |   |
| Net (increase) decrease in notes receivable                                                                                               |   | 2,684                       |    | 1,038 |   | (2,857 | ) |
| Net decrease in security deposits                                                                                                         |   | (842                        | )       | (828 | ) | (35 | ) |
| Net increase (decrease) in other assets                                                                                                   |   | 266                         |    | 346 |   | (819 | ) |
| Net (increase) decrease in loans to employees                                                                                             |   | (339                        | )       | (14 | ) | 93 |   |
| Cash used in investing activities                                                                                                         |   | (151,753                    | )       | (100,640 | ) | (81,572 | ) |
|                                                                                                                                      |   |                        |    |   |   |   |   |
| **Cash Flows from Financing Activities**                                                                                                  |   |                        |    |   |   |   |   |
| Proceeds from issuance of term securitization notes, net of debt issue  costs                                                             |   | 4,592                       |    | 352,645 |   | — |   |
| Repayments of term securitization notes                                                                                                   |   | (49,279                     | )       | — |   | — |   |
| Proceeds from issuance of other senior notes                                                                                              |   | 153,608                     |    | 173,519 |   | 128,051 |   |
| Repayments of other senior notes                                                                                                          |   | (51,209                     | )       | (307,589 | ) | (75,147 | ) |
| Net proceeds (repayments) from revolving notes payable to banks                                                                           |   | 3,000                       |    | (21,000 | ) | 21,000 |   |
| Interest rate swap breakage costs                                                                                                         |   | (636                        | )       | (3,988 | ) | — |   |
| Purchase of treasury stock                                                                                                                |   | (495                        | )       | (219 | ) | (1,381 | ) |
| (Increase) decrease in restricted cash                                                                                                    |   | 86,031                      |    | (100,578 | ) | (5,336 | ) |
| Exercise of employee stock options                                                                                                        |   | 235                         |    | 27 |   | 300 |   |
| Repayment of employee stock ownership plan promissory note                                                                                |   | 105                         |    | 105 |   | 105 |   |
| Cash provided by financing activities                                                                                                     |   | 145,952                     |    | 92,922 |   | 67,592 |   |
| Net increase (decrease) in cash and cash equivalents                                                                                      |   | 2,797                       |    | 357 |   | (3,227 | ) |
| Cash and cash equivalents at beginning of year                                                                                            |   | 1,713                       |    | 1,356 |   | 4,583 |   |
| Cash and cash equivalents at end of year                                                                                                  |   | $                           | 4,510   |   | $ | 1,713 |   | $ | 1,356 |   |
|                                                                                                                                      |   |                        |    |   |   |   |   |
| Supplemental disclosures of cash flow information:                                                                                        |   |                        |    |   |   |   |   |
| Interest paid                                                                                                                             |   | $                           | 25,268  |   | $ | 25,371 |   | $ | 17,666 |   |
| Income taxes paid                                                                                                                         |   | 140                         |    | 228 |   | 150 |   |
| Non-cash transaction:                                                                                                                     |   |                        |    |   |   |   |   |
| Asset sale transfers in satisfaction of senior notes                                                                                      |   | $                           | 129,491 |   | $ | 93,297 |   | $ | — |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

5

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**HPSC, INC. and Subsidiaries**

 

**NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS**

 

**NOTE A. BUSINESSAND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

 

*Nature of Business_*HPSC, Inc. (“HPSC”) and its consolidatedsubsidiaries (the “Company”) provide financing, in the form of leases andnotes, for equipment and other practice related expenses to the medical andhealthcare professions. The Company does not carry any inventory. The Companyacquires the financed equipment from vendors at their customary selling priceto other customers. All leases are classified as direct financing leases. TheCompany also finances the acquisition of healthcare practices by healthcareprofessionals and provides financing for leasehold improvements, officefurniture and equipment, and certain other costs involved in opening ormaintaining a healthcare provider’s office. The Company periodically sellsleases and notes receivable in its securitization facilities and to variousbanks.

 

Through its wholly–ownedsubsidiary, American Commercial Finance Corporation (“ACFC”), the Company alsoprovides asset-based financing to manufacturing and distribution companies withborrowing requirements of generally less than $5,000,000.

 

*Basis of Consolidation_*The accompanying consolidated financial statementsinclude HPSC, Inc. and the following wholly-owned subsidiaries: ACFC, anasset-based lender engaged primarily in providing accounts receivable andinventory financing at variable rates, HPSC Bravo Funding LLC (“Bravo”), HPSCCapital Funding Inc. (“Capital”) (terminated in June 2001), and HPSC EquipmentReceivables 2000-1 LLC II, all special-purpose corporations formed inconnection with securitization facilities. HPSC Equipment Receivables 2000-1LLC I is a qualified non-consolidated special-purpose entity within the meaningof Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities, a replacement of SFAS No. 125”. All inter-company transactionshave been eliminated in consolidation.

 

*Use of Estimates_*The preparation of financial statements inaccordance with accounting principles generally accepted in the United Statesof America requires the Company to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of these consolidated financial statementsand the reported amounts of revenues and expenses during the reporting periods.A significant area requiring the use of management estimates is the allowancefor losses on leases and notes receivable. Actual results could differ fromthose estimates.

 

*Revenue Recognition_*The Company finances equipment only after acustomer’s credit has been approved and a lease or financing agreement for thetransaction has been executed. The Company performs ongoing credit evaluationsof its customers and maintains allowances for potential credit losses. When atransaction is initially activated, the Company records the minimum paymentsand the estimated residual value of the equipment, if any, associated with thetransaction. An amount equal to the sum of the payments due plus the residualvalue less the cost of the transaction is recorded as unearned income. Theunearned income is recognized as revenue over the life of the transaction usingthe interest method.  Recognition ofrevenue on these assets is suspended when a transaction enters the legalcollection phase. Also included in earned income are fees from various portfolioservice charges, gains and losses on prepayments, and miscellaneous incomeitems, net of initial direct cost amortization. Notes receivable are reportedat their outstanding principal balances. Interest income on notes receivable isrecognized as it is accrued.

 

*Sales of Leases and Notes Receivable_*The Company periodically sells leases and notesreceivable in its securitization facilities and to various banks. Gains onsales of leases and notes are recognized at the time of the sale. The gain iscomputed as the excess of the present value of the anticipated future cashflows plus the fair value of its retained subordinated interest, less initialdirect costs and expenses, and the Company’s current carrying value of theassets sold. The Company retains servicing responsibility for financing contractssold. Servicing fees on sold assets, which the Company believes to approximateits servicing costs, are deferred and recognized as revenue in proportion tothe estimated periodic servicing costs.

 

*Estimated Residual Value of Equipment at End of Lease Term*_ Residual values, representing the estimatedvalue of equipment at the end of the lease term, are recorded in theconsolidated financial statements at the inception of each lease.  These amounts are estimated by managementbased upon its experience and judgment, and generally equal 10% of the originalcost of the equipment.

 

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*Deferred Origination Costs_*The Company capitalizes initial direct costs thatrelate to the origination of leases and notes receivable in accordance withSFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated withOriginating or Acquiring Loans and Initial Direct Costs of Leases”. Theseinitial direct costs comprise certain specific activities related to processingrequests for financing, such as the costs to underwrite the transaction, toprepare and execute the documentation, filing fees, and commission payments.Deferred origination costs are amortized on the interest method over the lifeof the receivable as an adjustment of yield.

 

*Allowance for Losses_*The Company records an allowance for estimatedlosses in its portfolio. The allowance is based on an evaluation of itsportfolio quality, delinquency trends, general economic conditions, historicalloss experiences, as well as a specificanalysis of potential loss accounts.  Anaccount is either specifically reserved or written off when deemeduncollectible.

 

The Company occasionallyrepossesses equipment from lessees or borrowers who have defaulted on their obligationsto the Company. There was no such equipment held for resale atDecember 31, 2001 or 2000.

 

*Accounting for Stock-Based Compensation_*The Company accounts for stock-based compensationin accordance with Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees.” The Company applies the intrinsic value method under APB No. 25 tomeasure compensation expense related to grants of stock options, and hasdisclosed the pro forma information required by SFAS No. 123, “Accounting forStock-Based Compensation”.

 

*Income Taxes_*The Company accounts for income taxes inaccordance with SFAS No. 109, “Accounting for Income Taxes”.  Current tax liabilities or assets arerecognized, through charges or credits to the current tax provision, for theestimated taxes payable or refundable for the current year. Net deferred taxesare recognized, through charges or credits to the deferred tax provision, forthe estimated future tax effects, based on enacted tax rates, attributable totemporary differences. Deferred tax liabilities are recognized for temporarydifferences that will result in amounts taxable in the future, and deferred taxassets are recognized for temporary differences and tax benefit carryforwardsthat will result in amounts deductible or creditable in the future. The effectof enacted changes in tax law, including changes in tax rates, on thesedeferred tax assets and liabilities is recognized in income in the period thatincludes the enactment date. A deferred tax valuation reserve is established ifit is likely that all or a portion of the Company’s deferred tax assets willnot be realized. Changes in the deferred tax valuation reserve are recognizedthrough charges or credits to the deferred tax provision.

 

*Cash and Cash Equivalents_*The Company considers all highly liquidinvestments with maturities of three months or less when acquired to be cashequivalents.

 

*RestrictedCash_* As part of its servicing obligation under itssecuritization and bank agreements (Note C), the Company collects certain cashreceipts on financing contracts pledged or sold.  These collections are segregated in separate accounts for thebenefit of the entity to which the related leases and notes receivable werepledged or sold and are remitted to such entities on a monthly basis. InDecember 2000, the Company also held restricted cash received in connectionwith a prefunding arrangement provided through its term securitization for thesole purpose of acquiring additional financing contracts originated by theCompany during 2001.

 

*Interest Rate Swap Contracts_*Underthe terms of its securitization agreements (Note C), the Company is required toenter into interest rate swap contracts to manage its exposure to fluctuationsin interest rates. Interest rate swap contracts are used to convert substantialportions of the Company’s debt from a variable-rate to a fixed-rate ofinterest. The periodic net interest payments from the swap contracts arerecognized in the Company’s consolidated statements of operations as acomponent of interest expense. The Companydoes not hold or issue derivative financial instruments for trading purposesand is not a party to leveraged instruments. The Company has established acontrol environment that includes procedures for risk assessment and approval,reporting and monitoring of derivative financial instruments.

 

On January 1, 2001, the Company adopted SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities” as amended bySFAS No. 138.  SFAS No. 133, as amended,requires all derivative instruments to be recorded on the Consolidated BalanceSheet as either assets or liabilities and measured at fair value. Prior toJanuary 1, 2001, the Company accounted for interest rate swap contracts usingsettlement accounting.

 

The Company has designated its interest rate swapagreements as hedging its exposure to the variability in expected future cashflows attributable to its variable rate debt. Accordingly, the Company assessesthe effectiveness of the hedge for each reporting period. The fair value ofeach interest rate swap agreement is recorded at fair value on the ConsolidatedBalance Sheet. Unrealized gains or losses, representing the effective portionof the hedge, are excluded from earnings and reflected in stockholders’ equityas a separate component of accumulated other comprehensive income (loss), netof taxes. The ineffective portion of the hedge is determined by comparing thechanges in the fair value of the swap contract to changes in the fair value ofa

 

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hypothetical swap which has terms equal to the hedged debt. Anyineffective portion of the hedge is recognized in earnings. During the yearended December 31, 2001, the amount recognized by the Company in earningsrepresenting hedge ineffectiveness was not material to the results ofoperations.  Amounts will be reclassedout of accumulated other comprehensive income (loss) either as the hedged debtamortizes or as interest rates fluctuate.

 

*Property and Equipment_*Property and equipment used by the business arerecorded at cost and depreciated using the straight-line method over a periodof three to five years. Leasehold improvements are amortized over the shorterof the estimated life of the asset or the lease term. Net property, plant andequipment are included in other assets and were not material at December 31,2001 or 2000.

 

*Deferred Compensation_*Deferred compensation, which includes notesreceivable from the Company’s Employee Stock Ownership Plan (“ESOP”) anddeferred compensation related to restricted stock awards, was as follows atDecember 31:

 
|             |   | **2001**            |   | **2000** |   | **1999** |   |
|------------------|--------|---------------------|--------|----------|--------|----------|--------|
|             |   | **(in  thousands)** |   |
| ESOP             |   | $                   | 211    |     | $      | 316      |   | $ | 421 |   |
| Restricted stock |   | 94                  |   | 319      |   | 587      |   |
|             |   |                |   |     |   |     |   |
| Total            |   | $                   | 305    |     | $      | 635      |   | $ | 1,008 |   |

 

*DebtIssue Costs*_ Debt issue costs incurred in securing creditfacility financing are capitalized and subsequently amortized over the term ofthe credit facility.

 

*RecentlyIssued Accounting Pronouncements_* In June 2001, the FASBissued SFAS No. 141, “Business Combinations”, SFAS No. 142, “Goodwill and OtherIntangible Assets”, and SFAS No. 143, “Accounting for Asset RetirementObligations”.  In August 2001, SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets” wasissued.  SFAS No. 144, which supersedesand amends several earlier interpretations, addresses financial accounting andreporting for the impairment or disposal of a long-lived asset or group ofassets. This pronouncement provides impairment accounting guidance for tangiblelong-lived assets which are either held and used by the entity or disposed ofby sale or by other means. The accounting standards may also apply to theCompany’s residual interest in its leased assets. This Statement will beeffective January 1, 2002. The Company does not believe the adoption of thesefour standards will have a material effect on its consolidated financialstatements.

 

*Reclassifications_*Certain amounts in the 2000 and 1999 consolidatedfinancial statements have been reclassified to conform to the current yearpresentation.

 

**NOTE B. LEASESAND NOTES RECEIVABLE**

 

The Company’s financing contractportfolio consists of two general categories of assets.

 

The first category of assetsconsists of leases and notes receivable due in installments to HPSC, whichcomprise approximately 91% of the Company’s consolidated net investment inleases and notes at December 31, 2001 (90% at December 31, 2000). Themajority of these leases and notes are from licensed medical professionals,principally dentists, who practice in individual or small group practices.Approximately 70% of these leases and notes pertain to equipment financingwhile approximately 30% relate to practice financing, leasehold improvements,office furniture, working capital and supplies. The Company operatesprincipally in the healthcare finance market where the size of the transactionis $250,000 or less, generally referred to as the “small-ticket” market. Theaverage size of an obligor’s original obligation under a financing contractoriginated by the Company was approximately $38,000 as of December 31, 2001.The leases and notes due in installments are non-cancelable contracts providingfor a full payout at a fixed rate, with terms ranging from 12 to 84 months. TheCompany’s leases provide for a purchase option at maturity at the fair value ofthe equipment, generally equal to 10% of the original equipment cost.

 

The second category of assetsconsists of notes receivable due to ACFC, which comprise approximately 9% ofthe Company’s net investment in leases and notes at December 31, 2001 (10%at December 31, 2000).  These notesprimarily relate to commercial, asset-based, revolving lines of credit of $5million or less to small and medium-sized manufacturers and distributors, atvariable interest rates. ACFC typically makes accounts receivable loans toborrowers, which are secured by a security interest in all of the borrowers’assets. Advances on a revolving loan generally do not exceed 80% of aborrower’s eligible accounts receivable. ACFC also makes inventory loans notexceeding 50% of the value of an obligor’s active inventory.  Additionally, ACFC occasionally providesterm financing for equipment, which is secured by the machinery and equipmentof the obligor.  ACFC loans, whichtypically have terms of

 

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two to three years, are “fully followed”, whichmeans ACFC receives daily settlement statements of its borrower’s accountsreceivable and receives daily collections into ACFC controlled collectionaccounts.

 

The Company’s receivables aresubject to credit risk. To reduce this risk, the Company has adoptedunderwriting policies for approving leases and notes.   Additionally, the Company may be subject to limited recoursefrom leases and notes sold under certain securitization agreements (Notes C andD).  Such risk of loss to the Company isgenerally limited to the extent of any retained interest and residual valuesrelated to the sold financing contracts.

 

A summary of activity in theCompany’s consolidated allowance for losses for each of the years in the three–yearperiod ended December 31, 2001 is as follows:

 
|                       |   | **2001** |    | **2000**            |   | **1999** |   |
|----------------------------|--------|----------|---------|---------------------|--------|----------|--------|
|                       |   |     |    | **(in  thousands)** |   |     |   |
| Balance, beginning of year |   | $        | (14,170 | )                   | $      | (9,150   | )      | $ | (7,350 | ) |
| Provision for losses       |   | (9,409   | )       | (9,218              | )      | (4,489   | )      |
| Charge-offs                |   | 8,253    |    | 4,287               |   | 2,853    |   |
| Recoveries                 |   | (33      | )       | (89                 | )      | (164     | )      |
|                       |   |     |    |                |   |     |   |
| Balance, end of year       |   | $        | (15,359 | )                   | $      | (14,170  | )      | $ | (9,150 | ) |

 

The total gross contractualbalances of delinquent leases and notes due in installments, both owned andmanaged by the Company, which were over 90 days past due, amounted to$24,945,000 at December 31, 2001 compared to $23,759,000 atDecember 31, 2000. An account is considered delinquent when not paidwithin 30 days of the billing due date.

 

The Company’s agreements with itscustomers, except for its notes receivable, are non-cancelable and provide fora full payout at a fixed financing rate over terms of one to seven years.Scheduled future receipts on leases and notes due in installments, plus anticipatedcash flows on the retained interest in leases and notes sold, were as followsat December 31, 2001:

 
|                |   | **Leases and  Notes Due in  Installments** |    | **Retained  Interest in  Leases and  Notes Sold** |   |
|---------------------|--------|--------------------------------------------|---------|---------------------------------------------------|--------|
|                |   | **(in  thousands)**                        |    |
| 2002                |   | $                                          | 114,825 |                                              | $      | 7,442 |   |
| 2003                |   | 95,164                                     |    | 6,344                                             |   |
| 2004                |   | 80,694                                     |    | 4,875                                             |   |
| 2005                |   | 62,571                                     |    | 3,489                                             |   |
| 2006                |   | 43,894                                     |    | 2,114                                             |   |
| 2007 and thereafter |   | 31,315                                     |    | 1,516                                             |   |
| Total               |   | $                                          | 428,463 |                                              | $      | 25,780 |   |

 

**NOTE C. DEBT ANDSECURITIZATION FACILITIES**

 

*Revolving Credit Borrowings*- In May 2001 the Company renewed and amended itsrevolving credit facility (the “Revolver”). The Revolver provides the Companywith available borrowings of $83,500,000 through May 2002. Under the Revolver,the Company may borrow at variable interest rates of prime plus .75% to 1.25% andat LIBOR plus 2.25% to 2.75%, depending upon its compliance with certainperformance covenants. The weighted-average interest rate on outstandingborrowings was 4.6% and 8.6% at December 31, 2001 and 2000, respectively.All HPSC and ACFC assets, including ACFC stock, but excluding assetscollateralizing the senior notes, have been pledged as collateral under theRevolver. An officer of the Company is a member of an advisory committee of anaffiliate of a bank providing liquidity in the Revolver. At December 31, 2001,the Company had $52,000,000 outstanding under the Revolver.

 

*Senior Subordinated Notes*- In March 1997 the Company issued $20,000,000 ofunsecured senior subordinated notes (the “Notes”) due in 2007. The Notes bearinterest at a fixed rate of 11%, payable semi-annually on April 1 and October 1of each year. The Notes are redeemable at the option of the Company through theoperation of a sinking fund at established redemption prices, plus accruedinterest to the date of redemption. Beginning July 1, 2002, the Company isrequired to redeem through quarterly sinking fund payments $1,000,000 principalplus accrued interest to the redemption date. At December 31, 2001 the Companyhad outstanding senior subordinated notes of $19,985,000.

 

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*Senior Notes- Various Banks*- The Company periodically enters into secured,fixed term loan agreements with various banks for purposes of financing itsoperations. The loans are generally subject to certain recourse and performancecovenants. At December 31, 2001, the Company had on its consolidated balancesheet outstanding borrowings of $11,559,000 under such loan agreements, atannual interest rates ranging from 6.5% to 8.0%.  In 1995 and 1996, the Company also sold certain financingcontracts to various banks. These sales agreements are subject to covenantsthat, among other matters, may require the Company to repurchase the financingcontracts sold and/or make payments on the financing contracts when due. AtDecember 31, 2001, the total balance outstanding for these sold, off-balancesheet financing contracts was $579,000.

 

*Securitization Facilities-General*- The Company utilizes two primary securitizationfacilities to provide a substantial portion of its financing requirements: theBravo facility (the “Bravo Facility”) and the Equipment Receivables 2000-1 (“ER2000-1”). In connection with its securitization financing activities, theCompany has formed the following bankruptcy-remote, special-purpose entities:HPSC Bravo Funding LLC (“Bravo”), HPSC Equipment Receivables 2000-1 LLC I (“ER2000-1 LLC I”), and HPSC Equipment Receivables 2000-1 LLC II (“ER 2000-1 LLCII”). Securitization is a process in which pools of financing contracts aretransferred to a special-purpose entity which, in turn, issues notes toinvestors. The notes are secured by a pledge of the assets in the financingcontract pools. Principal and interest on the notes are paid from the cashflows generated from the financing contracts. In both securitizations, theCompany has retained the responsibility for servicing the financing contractportfolio. Under certain circumstances, the Company, as the servicer, may alsobe obligated to advance amounts due on a financing contract if an obligor failsto remit a payment when due. The Company is reimbursed for such advances fromavailable funds upon subsequent collection from the obligor.

 

For accounting purposes, theCompany treats these securitizations as either financings (on-balance sheettransactions) or sales (off-balance sheet transactions) pursuant to theaccounting provisions of SFAS No. 140. In an on-balance sheet securitization,the securitized financing contracts are recorded as assets with the proceedsrecorded as senior notes on the Company’s consolidated balance sheet. In thecase of a transfer which qualifies as a sale, the financing contracts areremoved from the consolidated balance sheet and a gain or loss is recognized atthe time of the sale. For these off-balance sheet transactions, the previouscarrying amount of the transferred assets is allocated between the assets soldand a retained interest based on the relative fair values of the assets on thedate of transfer. The Company estimates fair value based on the present valueof expected future cash flows using management’s best estimates of anticipatedcredit losses and discount rates. Management believes that such key estimatesare consistent with those that would be used by other market participants indetermining fair value. In both on-and-off-balance sheet securitizations, theCompany retains the right to continue to service the portfolio and receives aservicing fee for doing so. The Company believes that its servicing feeapproximates its estimated servicing costs but has limited market basis toassess the fair value of its servicing asset. Accordingly, the Company hasvalued its servicing asset and deferred liability at zero. The securitizationdisclosures required by SFAS No. 140 are included in Note D.

 

*Securitizations-Bravo Facility*- The Bravo Facility, as amended, provides theCompany with available borrowings of up to $385,000,000. Under the terms of theBravo Facility, the Company contributes certain financing contracts to Bravowhich, in turn, either pledges or sells its interests in these contracts to acommercial paper conduit entity. Credit enhancement is provided to the noteholders through guarantees provided by MBIA, Inc. as to the payment ofprincipal and interest on the notes. In the case of financing contracts pledgedby Bravo, the financing contracts along with the associated debt of Bravo tothe conduit entity are included on the Company’s consolidated balance sheet. AtDecember 31, 2001 these outstanding borrowings totaled $126,468,000 with aweighted-average interest rate of 5.45%. In the case of financing contractssold by Bravo, the financing contracts and associated debt are removed from theCompany’s consolidated balance sheet. Risk of loss to the Company is limited tothe extent of the Company’s retained interest and residual values in thefinancing contracts sold. At December 31, 2001, the total outstanding balanceof these sold, off-balance sheet financing contracts was $74,388,000.

 

The Company obtained a waiver fornon-compliance with its tangible net worth, interest coverage, and leveragecovenants in the Bravo Facility for each quarter of its fiscal year 2001. Thisnon-compliance resulted primarily from costs incurred in connection withcompleting the ER 2000-1 asset securitization transaction in December 2000 and theimpact of adoption of SFAS No. 133.

 

*Securitizations-Equipment Receivables 2000-1*- In December 2000, the Company completed a$527,106,000 private placement term securitization. HPSC, along with itssubsidiaries ACFC, Bravo, and HPSC Capital Funding, Inc (a special-purposeentity terminated in June 2001), transferred certain leases, notes andrevolving loans to two newly formed special-purpose entities, ER 2000-1 LLC Iand ER 2000-1 LLC II. These entities issued notes to finance the purchase of,and loan against the collateral consisting of the leases and notes transferredfrom HPSC, ACFC, Bravo and Capital.  ER2000-1 LLC I was formed to meet the criteria of a qualifying unconsolidatedspecial-purpose entity within the meaning of SFAS Nos. 125 and 140, while ER2000-1 LLC II was formed to be a consolidated special-purpose entity.

 

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In the case of financingcontracts sold to ER 2000-1 LLC I, the financing contracts and associated debtare removed from the Company’s Consolidated Balance Sheet. Risk of loss to theCompany is limited to the extent of the Company’s retained interest andresidual values in the financing contracts sold. At December 31, 2001, thetotal outstanding balance of these sold, off-balance sheet financing contractswas $212,602,000. Financing contracts transferred to ER 2000-1 LLC II werepledged as collateral for the notes, with the financing contracts andassociated indebtedness included in the Company’s Consolidated Balance Sheet.At December 31, 2001 this outstanding indebtedness totaled $146,779,000 with aweighted-average interest rate of 6.67%.

 

HPSC provided additional creditenhancement to the ER 2000-1 note holders through the creation of a cashreserve account and a residual payment account. Pursuant to the terms of the ER2000-1 securitization agreements, certain excess cash flows generated by thefinancing contract portfolio are deposited to the cash reserve account orresidual payment account, up to agreed upon limits. These interest-bearingrestricted cash accounts are available to fund monthly interest and principalpayments on the ER 2000-1 notes in the event of deficiencies from monthlycollections on the financing contracts. At December 31, 2001, the balance in the restricted cash reserve accountwas $10,191,000 and the balance in the restricted cash residual payment accountwas $1,433,000. The Company may also provide additional credit enhancementthrough the substitution of new leases and notes for leases and notes previouslycontributed into ER 2000-1 LLC II, up to certain defined limits.

 

ER 2000-1 LLC I and ER 2000-1 LLCII originally issued seven classes of equipment contract backed notes and oneclass of equipment contract backed variable funding notes (“VFN”). To providecredit enhancement, the classes of notes are structured by means of paymentseniority/subordination. Recourse to HPSC and ACFC is limited to the extent ofthe financing contracts contributed to the financing.  Details of the notes, ranked in senior/subordinated priority, areas follows at December 31, 2001:

 
| **Class**          |   | **Original Principal Balance (Note 1)** |    | **Remaining Principal Balance (Note 1)** |   | **Coupon Rate,****per annum** |   | **Interest Accrual Method** |   | **Rating****(Unaudited)** |   |
|--------------------|--------|-----------------------------------------|---------|------------------------------------------|--------|-------------------------------|--------|-----------------------------|--------|---------------------------|--------|
|               |   | **($ in thousands)**                    |    |
| Class A            |   | $                                       | 414,466 |                                     | $      | 300,455                       |   | 1 Month USD  LIBOR+0.30     | %      | Actual/360                |   | Aaa/AAA |   |
| Class B-1          |   | 29,959                                  |    | 21,718                                   |   | 1  Month USD  LIBOR + 0.50    | %      | Actual/360                  |   | Aa3/AA                    |   |
| Class B-2          |   | 13,267                                  |    | 9,618                                    |   | 7.23                          | %      | 30/360                      |   | Aa3/AA                    |   |
| Class C            |   | 19,070                                  |    | 13,825                                   |   | 7.70                          | %      | 30/360                      |   | A3/A                      |   |
| Class D            |   | 5,085                                   |    | 3,686                                    |   | 8.11                          | %      | 30/360                      |   | Baa3/BBB                  |   |
| Class E            |   | 8,899                                   |    | 6,451                                    |   | 10.00                         | %      | 30/360                      |   | Ba2/BB                    |   |
| Class F            |   | 6,360                                   |    | 4,608                                    |   | 12.91                         | %      | 30/360                      |   | B1                        |   |
| Class VFN (Note 2) |   | 30,000                                  |    | —                                   |   | 1  Month USD  LIBOR + 1.00    | %      | Actual/360                  |   | —                    |   |
| Total              |   | $                                       | 527,106 |                                     | $      | 360,361                       |   |                        |   |                      |   |   |   |
|                    |        |                                         |         |                                          |        |                               |        |                             |        |                           |        |  |  |  |  |  |

 

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Note1:    Principal balances includeoutstanding obligations which reflect both off-balance sheet sales of financingcontracts (ER 2000-1 LLC I) as well ason-balance sheet debt obligations (ER2000-1 LLC II).

Note2:   The Class VFN notes were neverissued, however, remain available to the Company.

 

A summary of the Company’s totaldebt obligations and the total on-and-off-balance sheet financing contractsoutstanding through the Company’s various securitization facilities at December31, 2001, is as follows:

 
|                                                |   | **On-Balance  Sheet Debt  Obligations** |    | **Off-Balance Sheet  Sold Financing  Contracts** |   | **Total** |   |
|-----------------------------------------------------|--------|-----------------------------------------|---------|--------------------------------------------------|--------|-----------|--------|
|                                                |   | **(in thousands)**                      |    |
| Revolving credit arrangement, due May 2002          |   | $                                       | 52,000  |                                             | $      | —    |   | $ | 52,000 |   |
| Unsecured Senior Subordinated Notes, due March 2007 |   | 19,985                                  |    | —                                           |   | 19,985    |   |
| Various banks, due June 2004 through January 2007   |   | 11,559                                  |    | 579                                              |   | 12,138    |   |
| Bravo, due June 2003                                |   | 126,468                                 |    | 74,388                                           |   | 200,856   |   |
| ER 2000-1 LLC I and LLC II, due December 2008       |   | 147,759                                 |    | 212,602                                          |   | 360,361   |   |
| Subtotal                                            |   | 357,771                                 |    | 287,569                                          |   | 645,340   |   |
| Less: Original issue discount on ER 2000-1 notes    |   | (980                                    | )       | —                                           |   | (980      | )      |
| Total                                               |   | $                                       | 356,791 |                                             | $      | 287,569   |   | $ | 644,360 |   |

 

Scheduled future annualmaturities of the Company’s on-balance sheet debt obligations, as detailedabove, is as follows at December 31, 2001:

 

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|                |   | **Revolver**       |   | **Bravo** |   | **ER 2000-1(at face value)** |   | **Various  Banks** |    | **Senior Subordinated** |   | **Total** |   |
|---------------------|--------|--------------------|--------|-----------|--------|------------------------------|--------|--------------------|---------|-------------------------|--------|-----------|--------|
|                |   | **(in thousands)** |   |
| 2002                |   | $                  | 52,000 |      | $      | 27,678                       |   | $                  | 49,248  |                    | $      | 2,657     |   | $ | 1,998 |   | $ | 133,581 |   |
| 2003                |   | —             |   | 25,116    |   | 32,347                       |   | 3,018              |    | 3,997                   |   | 64,478    |   |
| 2004                |   | —             |   | 23,028    |   | 27,656                       |   | 2,689              |    | 3,997                   |   | 57,370    |   |
| 2005                |   | —             |   | 20,457    |   | 19,447                       |   | 2,154              |    | 3,997                   |   | 46,055    |   |
| 2006                |   | —             |   | 15,859    |   | 13,207                       |   | 1,041              |    | 3,997                   |   | 34,104    |   |
| 2007 and thereafter |   | —             |   | 14,330    |   | 5,854                        |   | —             |    | 1,999                   |   | 22,183    |   |
| Total               |   | $                  | 52,000 |      | $      | 126,468                      |   | $                  | 147,759 |                    | $      | 11,559    |   | $ | 19,985 |   | $ | 357,771 |   |
|                     |        |                    |        |           |        |                              |        |                    |         |                         |        |           |        |  |  |  |  |  |  |  |

 

**NOTE D.ADDITIONAL SECURITIZATION DISCLOSURES**

 

As described in Note C, the Company routinely sellsleases and notes due in installments pursuant to sales and securitizationagreements. Under each of its securitization agreements, the Company continuesto service the financing contracts sold, subject to complying with certaincovenants. The Company believes that its servicing fee approximates itsestimated servicing costs, but it has limited market basis to assess the fairvalue of its servicing asset. Accordingly, the Company has valued its servicing asset and deferredliability at zero.  The Companyrecognizes servicing fee revenue as earned over the servicing period inproportion to its servicing costs. For fiscal years ended December 31, 2001,2000, and 1999, the Company recognized servicing fee revenues of $1,349,000,$405,000, and $285,000, respectively.

 

The following is a summary of certain cash flowactivity received from and (paid to) securitization facilities for each of theyears for the two-year period ended December 31, 2001:

 
|                                                                                                                             |   | **2001**            |    | **2000** |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|----------|--------|
|                                                                                                                             |   | **(in  thousands)** |    |
| Asset sale transfers in satisfaction of  senior notes                                                                            |   | $                   | 129,491 |     | $      | 93,297 |   |
| Cash proceeds from new securitizations                                                                                           |   | 26,145              |    | 50,818   |   |
| Cash proceeds from term securitization for negotiated reacquisition of  contracts outstanding under Bravo and Capital Facilities |   | —              |    | 134,741  |   |
| Payment to Bravo and Capital for negotiated reacquisition of contracts  previously sold                                          |   | —              |    | (124,937 | )      |
| Cash collections from obligors, remitted to transferees                                                                          |   | (91,004             | )       | (49,820  | )      |
| Servicing fees received                                                                                                          |   | 1,460               |    | 913      |   |
| Other cash flows retained by servicer                                                                                            |   | 7,075               |    | 3,542    |   |
| Net servicing (advances) repayments                                                                                              |   | (1,863              | )       | —   |   |
|                                                                                                                                  |        |                     |         |          |        |  |  |

 

A portion of the proceeds received from the ER 2000-1term securitization was used by ER 2000-1 LLC I and ER 2000-1 LLC II topurchase financing contracts from the Bravo and Capital Facilities. Thesenegotiated transactions were completed in December 2000.

 

The following is a summary of the performance of theCompany’s total owned and managed financing contracts:

 
|                                               |   | **Total Net  Investment** |    | **Net Investment over****90  Days Past Due** |   | **Net Credit Losses** |   |
|----------------------------------------------------|--------|---------------------------|---------|----------------------------------------------|--------|-----------------------|--------|
|                                               |   | **At December 31,**       |    | **For Year Ended December 31,**              |   |
|                                               |   | **2001**                  |    | **2000**                                     |   | **2001**              |   | **2000** |   | **2001** |   | **2000** |   |
|                                               |   | **(in thousands)**        |    |
| Licensed professional financing                    |   | $                         | 620,795 |                                         | $      | 526,589               |   | $ | 20,055 |   | $ | 18,979 |   | $ | 7,655 |   | $ | 3,798 |   |
| Commercial and industrial financing                |   | 28,480                    |    | 30,909                                       |   | —                |   | — |   | 565 |   | 400 |   |
| Total owned and managed                            |   | 649,275                   |    | 557,498                                      |   | $                     | 20,055 |   | $ | 18,979 |   | $ | 8,220 |   | $ | 4,198 |   |
| Less:                                              |   |                      |    |                                         |   |                  |   |   |   |   |   |   |   |
| Securitized licensed professional financing assets |   | 251,410                   |    | 188,726                                      |   |                  |   |   |   |   |   |   |   |
| Total owned                                        |   | $                         | 397,865 |                                         | $      | 368,772               |   |   |   |   |   |   |   |   |   |

 

12

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The Company’s primary exposure indetermining the fair value of its retained interest in securitized financingcontracts is credit risk associated with the underlying obligors on thesecontracts. The Company’s retained interest in its financing contracts issubordinate to the interests of its credit providers.  In recording the net gain upon the sale of financing contractsand the fair value of its retained interest, the Company assumes a loss rate ofapproximately 0.50% per annum on a static pool basis, and discounts itsretained interest at implicit rates ranging from 12% to 14.5%.  Prepayment risk on securitized financingcontracts is limited due to the Company’s prepayment policies with itsobligors. To eliminate interest rate risk, the Company enters into interest rateswap contracts as a hedge against its variable rate obligations.  The fair value of the retained interest inthe financing contracts sold is reviewed for impairment on a quarterly basis.  Risk of loss to the Company under its Bravoand ER 2000-1 sales agreements is limited to the extent of any retainedinterest and residual values of the financing contracts sold to thosefacilities.

 

The following is a summary atDecember 31, 2001 of key assumptions and the sensitivity of the fair value of retained interest cash flowsto immediate 10 percent and 20 percent adverse changes in those assumptions:

 
|                                       |   | **Current**          |   | **10%** |   | **20%** |   |
|--------------------------------------------|--------|----------------------|--------|---------|--------|---------|--------|
|                                       |   | **($ in thousands)** |   |
| Retained interest                          |   | $                    | 25,780 |    |   |    |   |   |
| Expected credit losses (annual rate)       |   | .5                   | %      | $       | (48    | )       | $      | (97 | ) |
| Residual cash flows discount rate (annual) |   | 12.6                 | %      | $       | (333   | )       | $      | (654 | ) |
|                                            |        |                      |        |         |        |         |        |  |  |  |

 

These sensitivities are presentedas hypothetical assumptions and do not reflect actual experience.  Changes in the fair value based on a 10percent variation in assumptions generally cannot be extrapolated because therelationship of the change in assumption to the change in the fair value maynot be linear.  Also, the effect of avariation in a particular assumption on the fair value of the retained interestis calculated without changing any other assumption; in reality, the change inone assumption may result in changes in another, which may magnify orcounteract the sensitivities.

 

**NOTE E.  DERIVATIVE INSTUMENTS**

 

At December 31, 2001, the Company had nine interestrate swap contracts outstanding hedging variable-rate exposures to on-balancesheet debt obligations and seven interest rate swap contracts assigned tonon-consolidated entities for the purpose of hedging variable-rate exposuresfor sold financing contracts. The net fair value of the swap contracts hedgingon-balance sheet debt obligations, which is recorded on the Company’s balancesheet at December 31, 2001, was $7,221,000 ($7,230,000 in the Interest RateSwap Contract liability account and $9,000 in Other Assets). The fair value ofthe swap contracts hedging off-balance sheet amounts, which is not recorded onthe Company’s balance sheet, was a net liability of $8,865,000 at December 31,2001.

 

An officer of the Company is a member of an advisorycommittee of an affiliate of a counterparty to certain interest rate swapcontracts.

 

The Company’s activity in accumulated othercomprehensive loss related to derivatives classified as cash flow hedges forthe year ended December 31, 2001 is as follows:

 

|                                                                                          |   | **2001**                                  |   |
|-----------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                          |   | **(in thousands, net of deferred taxes)** |   |
| Beginning balance, January 1                                                                  |   | $                                         | — |   |
| Cumulative effect adjustment upon the adoption of SFAS No. 133                                |   | (1,062                                    | )      |
| Change in fair value of derivatives during the period                                         |   | (3,454                                    | )      |
| Losses reclassified into net income                                                           |   | 132                                       |   |
| Accumulated derivative loss included in accumulated other  comprehensive loss, at December 31 |   | $                                         | (4,384 | ) |

 

13

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During the twelve months ended December 31, 2001, theCompany’s interest rate swaps effectively offset changes in the hedged portionof the cash flows of the Company’s variable-rate debt obligations. The lossesreclassified into net income in the above table primarily relate to a change inthe fair value of a terminated swap contract recognized in net income upon theearly repayment of the related hedged debt. The total pretax cost to terminatethe swap contract was $280,000 and is reflected as a component of selling,general and administrative expenses for the year ended December 31, 2001.

 

**NOTE F.  COMMITMENTS AND CONTINGENCIES**

 

The Company leases various officelocations under non-cancelable lease arrangements that have initial terms ofthree to six years and may provide renewal options from one to five years. Rentexpense under all operating leases was $875,000, $828,000, and $746,000 for2001, 2000, and 1999, respectively.

 

Future minimum lease paymentsunder non–cancelable operating leases as of December 31, 2001 are asfollows:

 

|                |   | **(in thousands)** |   |
|---------------------|--------|--------------------|--------|
| 2002                |   | $                  | 774    |   |
| 2003                |   | 562                |   |
| 2004                |   | 264                |   |
| 2005 and thereafter |   | —             |   |
| Total               |   | $                  | 1,600  |   |

 

Although the Company is fromtime to time subject to actions or claims for damages in the ordinary course ofits business and engages in collection proceedings with respect to delinquentaccounts, the Company is aware of no such actions, claims, or proceedingscurrently pending or threatened that are expected to have a material adverseeffect on the Company’s business, operating results or financial condition.

 

**NOTE G.  INCOME TAXES**

 

Deferred income taxes reflect theimpact of “temporary differences” between the amount of assets and liabilitiesfor financial reporting purposes and such amounts as measured by tax laws andregulations.

 

Income tax expense (benefit) consist of thefollowing: 

 
|                       |   | **Year Ended December 31,** |   |
|----------------------------|--------|-----------------------------|--------|
|                       |   | **2001**                    |   | **2000** |   | **1999** |   |
|                       |   | **(in  thousands)**         |   |
| Federal:                   |   |                        |   |   |   |   |   |
| Current                    |   | $                           | 73     |   | $ | 7 |   | $ | 111 |   |
| Deferred                   |   | 1,669                       |   | 108 |   | 1,408 |   |
| State:                     |   |                        |   |   |   |   |   |
| Current                    |   | 74                          |   | 827 |   | 700 |   |
| Deferred                   |   | 338                         |   | (798 | ) | (312 | ) |
|                       |   |                        |   |   |   |   |   |
| Provision for income taxes |   | $                           | 2,154  |   | $ | 144 |   | $ | 1,907 |   |

 

A reconciliation of the U.S.federal statutory income tax rate and the effective tax rate as a percentage ofpre–tax income for each year is as follows: 

 
|                                               |   | **Year Ended December 31,** |   |
|----------------------------------------------------|--------|-----------------------------|--------|
|                                               |   | **2001**                    |   | **2000** |   | **1999** |   |
| Statutory rate                                     |   | 34.0                        | %      | 34.0 | % | 34.0 | % |
| State taxes net of U.S. federal income tax benefit |   | 5.1                         |   | 8.3 |   | 5.5 |   |
| Non-deductible expenses                            |   | 1.0                         |   | 20.0 |   | 1.7 |   |
|                                               |   |                        |   |   |   |   |   |
|                                               |   | 40.1                        | %      | 62.3 | % | 41.2 | % |

 

14

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The Company’s effective tax ratefor 2000 increased due to the effect of comparing an equivalent level ofpermanent non-deductible expenses to a significantly lower pre-tax income forthe year.

 

The items comprising asignificant portion of net deferred tax (assets) liabilities are as follows atDecember 31:

 
|                                                          |   | **2001**            |    | **2000** |   |
|---------------------------------------------------------------|--------|---------------------|---------|----------|--------|
|                                                          |   | **(in  thousands)** |    |
| Net operating loss carryforwards and tax credit carryforwards |   | $                   | (12,488 | )        | $      | (10,674 | ) |
| Accrued expenses and other                                    |   | (2,258              | )       | (1,556   | )      |
| Miscellaneous                                                 |   | (194                | )       | (152     | )      |
| Tax effect of accumulated comprehensive loss (Note 1)         |   | (2,813              | )       | —   |   |
| Accounting for lease contracts and notes (Note 2)             |   | 26,932              |    | 22,367   |   |
| Net deferred income tax liability                             |   | $                   | 9,179   |     | $      | 9,985 |   |

 

----

Note 1:   The tax effect of accumulated comprehensiveloss arises primarily from the recording of the Company’s interest rate swapcontracts on the balance sheet at fair value (net of tax), pursuant to SFAS No.133, which became effective for the Companyon January 1, 2001.

Note2:   The deferred tax liability from theaccounting for leases and notes relates to temporary differences between bookand tax treatment of sold securitized direct financing lease contracts andnotes receivable.

 

At December 31, 2001, the Company had federal andstate net operating loss carryforwards of approximately $30,400,000 and$48,700,000, respectively.  The federalnet operating loss carryforwards expire in the years 2018 through 2021, whilethe state net operating loss carryforwards expire in the years 2002 through2021.

 

**NOTE H.  STOCKHOLDERS’ EQUITY AND EARNINGS PER SHARE**

 

*CommonStock* - The Company has 15,000,000 shares authorized and4,779,530 shares outstanding at December 31, 2001. Of the outstanding shares,300,000 shares have been issued to the Company’s ESOP (Note J), 124,000 shareshave been issued to certain employees under the 1995 Stock Incentive Plan (NoteI), and 615,765 shares are held intreasury.

 

*PreferredStock* - The Company has 5,000,000 shares of $1.00 par valuepreferred stock authorized with no shares outstanding at December 31,2001.  (Note K, Preferred Stock PurchaseRights Plan.)

 

*TreasuryStock* - In December 2000, the Board of Directors approved anincrease to the stock repurchase program whereby the Company may repurchase upto an additional 250,000 shares of the Company’s common stock subject tomaximum dollar limitations as set forth under the Company’s Revolving LoanAgreement and Senior Subordinated Note financings. Based on current marketvalues at December 31, 2001 and the limitations as set forth in its debtagreements, the Company may repurchase up to an additional 166,000 shares ofits common stock.  No time limit hasbeen established for the repurchase program. The Company expects to use therepurchased stock to meet current and future requirements of its employee stockplans. During 2001, the Company repurchased 69,288 shares of its common stockfor approximately $495,000.

 

*Earningsper Share* - The Company’s basic net income per sharecalculation is based on the weighted-average number of common sharesoutstanding, which does not include unallocated shares under the Company’s ESOP(Note J), restricted shares issued under the Stock Plans (Note I), treasurystock, or any shares issuable upon the exercise of outstanding stockoptions.  Diluted net income per shareincludes the weighted-average number of common shares subject to stock optionsand contingently issuable restricted stock, as calculated under the treasurystock method, but not treasury stock or unallocated shares under the Company’sESOP.

 

The following is a reconciliation of the numeratorsand denominators of the basic and diluted net income per share:

 
|                                       |   | **Year Ended December 31,**                             |   |
|--------------------------------------------|--------|---------------------------------------------------------|--------|
|                                       |   | **2001**                                                |   | **2000** |   | **1999** |   |
|                                       |   | **(in thousands, except per share  and share amounts)** |   |
| Basic net income per share:                |   |                                                    |   |   |   |   |   |
| Net income                                 |   | $                                                       | 3,216  |   | $ | 87 |   | $ | 2,719 |   |
|                                       |   |                                                    |   |   |   |   |   |
| Weighted-average common shares outstanding |   | 3,965,378                                               |   | 3,879,496 |   | 3,766,684 |   |
|                                       |   |                                                    |   |   |   |   |   |
| Basic net income per share                 |   | $                                                       | 0.81   |   | $ | 0.02 |   | $ | 0.72 |   |
|                                       |   |                                                    |   |   |   |   |   |
| Diluted net income per share:              |   |                                                    |   |   |   |   |   |
| Net income                                 |   | $                                                       | 3,216  |   | $ | 87 |   | $ | 2,719 |   |
|                                       |   |                                                    |   |   |   |   |   |
| Weighted-average common shares outstanding |   | 3,965,378                                               |   | 3,879,496 |   | 3,766,684 |   |
| Stock options and restricted shares        |   | 354,295                                                 |   | 413,154 |   | 669,792 |   |
| Total diluted shares                       |   | 4,319,673                                               |   | 4,292,650 |   | 4,436,476 |   |
|                                       |   |                                                    |   |   |   |   |   |
| Diluted net income per share               |   | $                                                       | 0.74   |   | $ | 0.02 |   | $ | 0.61 |   |

 

15

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**NOTE I. STOCKOPTION AND STOCK INCENTIVE PLANS**

 

*Stock Option Plans_*The following is a historical summary of the Company’s various stock option plans forwhich stock options remain outstanding at December 31, 2001:

 
| **Stock Option  Plan Name**                             |   | **Plan Inception Date** |   | **Plan Termination Date (if applicable)**       |
|---------------------------------------------------------|--------|-------------------------|--------|-------------------------------------------------|
| Employee Stock Option Plan (the  “1983 Plan”) |   | March 1983              |   | May 1995 (upon approval of the  1995 Plan)      |
|                                                    |   |                    |   |                                            |
| Stock Option Plan (the “1986  Plan”)          |   | March 1986              |   | May 1995 (upon approval of the  1995 Plan)      |
|                                                    |   |                    |   |                                            |
| 1994 Stock Plan (the “1994  Plan”)            |   | March 1994              |   | May 1995 (upon approval of the  1995 Plan)      |
|                                                    |   |                    |   |                                            |
| 1995 Stock Incentive Plan (the  “1995 Plan”)  |   | May 1995                |   | February 1998 (upon approval of  the 1998 Plan) |
|                                                    |   |                    |   |                                            |
| 1998 Stock Incentive Plan (the  “1998 Plan”)  |   | February 1998           |   | April 2000 (upon approval of  the 2000 Plan)    |
|                                                    |   |                    |   |                                            |
| 2000 Stock Incentive Plan (the  “2000 Plan”)  |   | April 2000              |   |                                            |

 

Options granted under the 1983Plan are non-qualified options granted at an exercise price of not less than85% of the fair market value of the common stock on the date of grant. Optionsgranted under the 1986 Plan and the 1994 Plan are non-qualified stock optionsgranted at an exercise price equal to the market price of the common stock onthe date of grant. In February 1999, 15,000 five-year options issued under the1994 Plan, which were scheduled to expire in 1999, were extended for anadditional five years.  Upon theextension of the options, the Company recorded compensation expense of $68,000,computed as the difference between the original option exercise price on thedate of grant and the market price of the Company’s stock (the intrinsic value)on the date of the extension.

 

*1995 Plan_*Upon approval of the 1995 Plan in May 1995, 550,000 shares wereinitially reserved for the issuance of stock options or awards of restrictedstock.  The Company has outstandingstock options and awards of restricted stock under its 1995 Plan.  The options are incentive stock options andnon-qualified stock options and were granted at an exercise price equal to themarket price of the Company’s common stock on the date of the grant. Restrictedshares of common stock awarded under the 1995 Plan remain unvested untilcertain performance and service conditions are both met.

 

The performance condition forrestricted stock issued under the 1995 Plan is met with respect to 50% of therestricted shares if and when during the five-year period after the date ofgrant (the “Performance Period”) the closing price of the Company’s common stock,as reported for a consecutive 10-day period on the stock exchange for which theCompany’s stock is traded, equals at least 134.175% of the closing price on thegrant date (the “Partial Performance Condition”). The performance condition ismet with respect to the remaining 50% of the restricted shares if and whenduring the Performance Period the closing price of the Company’s common stock,as reported for a consecutive 10-day period on the stock exchange for which theCompany’s stock is traded, equals at least 168.35% of the closing price on thegrant date (the “Full Performance Condition”).

 

The service condition forrestricted stock issued under the 1995 Plan is met with respect to allrestricted shares (provided that the applicable performance condition has alsobeen met) by the holder’s continuous service to the Company throughout thePerformance Period, provided that such holder shall also have completed fiveyears of continued service with the Company from the date of grant. Upon achange of control of the Company (as defined in the 1995 Plan), all restrictedstock awards granted prior to such change of control become fully vested.

 

Upon the termination of aholder’s employment by the Company without cause or by reason of death ordisability during the Performance Period, any restricted stock awards for whichthe applicable performance condition is satisfied no later than four monthsafter the date of such termination of employment shall become fully vested.

 

16

----

 

A summary of restricted stockawards issued pursuant to the 1995Plan is as follows:

 
| **Date of  restricted stock awards**        |   | **May 1995** |   | **May 1995** |   | **May 1997** |   |
|---------------------------------------------|--------|--------------|--------|--------------|--------|--------------|--------|
| No. of restricted shares awarded (Note 1)   |   | 332,000      |   | 5,000        |   | 126,000      |   |
| Partial Performance Condition, per share    |   | $            | 5.90   |         | $      | 6.04         |   | $ | 8.05 |   |
| Full Performance Condition, per share       |   | $            | 7.37   |         | $      | 7.58         |   | $ | 10.10 |   |
| Date Partial Performance Condition achieved |   | Jun  1996    |   | Jun  1996    |   | May  1998    |   |
| Date Full Performance Condition achieved    |   | Apr  1998    |   | Apr  1998    |   | Aug  1999    |   |
| Date service condition achieved             |   | May  2000    |   | May  2000    |   | (Note  2     | )      |

 

----

Note1:   In April 1998, 150,000 outstandingrestricted shares were forfeited in exchange for stock options granted pursuantto the 1995 Plan.

Note2:   Service condition on the May 1997awards is expected to be fulfilled May 2002.

 

At the time each performancecondition was met, the Company recorded additional paid-in capital and deferredcompensation in an amount equal to the number of shares granted times therespective performance condition price per share.  Compensation expense is then recognized on a straight-line basisover the five-year service period beginning on the date of grant.  A cumulative adjustment was recorded on thedate the performance conditions were met to recognize retroactivelycompensation expense from the date of the issuance to the date the performancecondition was met.  In 2001, 2000, and1999, the Company recognized $225,000, $268,000, and $647,000, respectively, incompensation expense related to restricted stock awards under its 1995 Plan.

 

*1998Plan*_ Upon the approval ofthe 1998 Plan in February 1998, 550,000shares of common stock were reserved for the issuance of stock optionsand/or awards of restricted stock.  In addition, shares subject to options or stockawards under the 1995 Plan that expired or were terminated unexercised weremade available for issuance as stock options or restricted stock awards underthe 1998 Plan. Options outstanding under the 1998 Plan are either incentivestock options or non-qualified stock options. The exercise price for options granted is the average of the closingprices of the common stock on each of the days on which the stock was tradedduring the 30-calendar day period ending on the day before the date of theoption grant. No restricted shares were awarded under the 1998 Plan.

 

*2000 Plan_*In April 2000, the 2000 Plan was approved, at which time 450,000 sharesof the Company’s common stock were reserved for issuance as stock options orrestricted stock awards.  In addition,shares subject to options or stock awards under the 1998 Plan that expire orare terminated unexercised will be available for issuance as stock options orrestricted stock awards under the 2000 Plan.

 

The 2000 Plan provides that withrespect to options granted to key employees (except non-employee directors),the option term and the terms and conditions upon which the options may beexercised will be determined by the Compensation Committee of the Company’sBoard of Directors for each such option at the time it is granted. Optionsgranted to key employees of the Company are either incentive stock options ornon-qualified options, as designated by the Compensation Committee. Theexercise price for stock options may not be less than the closing price of theCompany’s common stock as reported in the *Wall Street Journal* on the date of theoption grant (the “2000 Plan Market Price”).

 

Each non-employee director whowas such at the conclusion of any regular annual meeting of the Company’sstockholders while the 2000 Plan is in effect and who continues to serve on theBoard of Directors is granted automatic options to purchase 1,000 shares of theCompany’s common stock at an exercise price not less than the 2000 Plan MarketPrice on the date of the option grant. Each automatic option is exercisableimmediately in full or for any portion thereof and remains exercisable for 10years after the date of grant, unless terminated earlier (as provided in the2000 Plan) upon or following termination of the holder’s service as a director.

 

As of December 31, 2001, theCompany had granted 441,500 stock options and no restricted stock awardspursuant to the 2000 Plan.

 

The following table summarizesstock option and restricted stock activity:

 
|                                       |   | **Options**              |   |                                     |   |
|--------------------------------------------|--------|--------------------------|--------|------------------------------------------|--------|
|                                       |   | **Number of****Options** |   | **Weighted -  Average  Exercise  Price** |   | **Restricted****Stock** |   |
| Outstanding at January 1, 1999             |   | 993,875                  |   | $                                        | 4.52   |   | 313,000 |   |
| Granted                                    |   | 141,000                  |   | 8.90                                     |   | — |   |
| Exercised                                  |   | (77,000                  | )      | 3.87                                     |   | — |   |
| Forfeited                                  |   | (4,000                   | )      | 5.13                                     |   | (2,000 | ) |
|                                       |   |                     |   |                                     |   |   |   |
| Outstanding at December 31, 1999           |   | 1,053,875                |   | 5.15                                     |   | 311,000 |   |
| Granted                                    |   | 330,500                  |   | 7.49                                     |   | — |   |
| Exercised                                  |   | (6,500                   | )      | 4.14                                     |   | — |   |
| Forfeited                                  |   | (10,000                  | )      | 9.08                                     |   | — |   |
| Release of restriction on restricted stock |   | —                   |   | —                                   |   | (187,000 | ) |
|                                       |   |                     |   |                                     |   |   |   |
| Outstanding at December 31, 2000           |   | 1,367,875                |   | 5.69                                     |   | 124,000 |   |
| Granted                                    |   | 131,000                  |   | 6.33                                     |   | — |   |
| Exercised                                  |   | (60,500                  | )      | 3.88                                     |   | — |   |
| Forfeited                                  |   | (24,000                  | )      | 6.44                                     |   | — |   |
|                                       |   |                     |   |                                     |   |   |   |
| Outstanding at December 31, 2001           |   | 1,414,375                |   | $                                        | 5.81   |   | 124,000 |   |

 

17

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The following table sets forthinformation regarding options outstanding at December 31, 2001:

 
|                           |   | **Options Outstanding** |   | **Options Exercisable**                                 |   |
|--------------------------------|--------|-------------------------|--------|---------------------------------------------------------|--------|
| **Range of  Exercise  Prices** |   | **Number of Options**   |   | **Weighted-Average Remaining Contractual Life (Years)** |   | **Weighted-   Average  Exercise Price** |   | **Number of  Options** |   | **Weighted-Average****Exercise Price** |   |
| $ 2.62 - 3.25                  |   | 232,875                 |   | 1.2                                                     |   | $ | 2.93 |   | 232,875 |   | $ | 2.93 |   |
| $ 3.56 - 4.88                  |   | 35,500                  |   | 3.0                                                     |   | 4.25 |   | 35,500 |   | 4.25 |   |
| $ 5.12 - 5.37                  |   | 563,500                 |   | 6.3                                                     |   | 5.30 |   | 477,500 |   | 5.29 |   |
| $ 6.00 - 6.63                  |   | 140,000                 |   | 8.6                                                     |   | 6.26 |   | 39,500 |   | 6.26 |   |
| $ 7.15 - 8.00                  |   | 321,500                 |   | 8.3                                                     |   | 7.51 |   | 131,000 |   | 7.52 |   |
| $ 8.83 - 9.54                  |   | 121,000                 |   | 7.6                                                     |   | 9.18 |   | 57,000 |   | 9.28 |   |
|                           |   |                    |   |                                                    |   |   |   |   |   |   |   |
| $ 2.62 - 9.54                  |   | 1,414,375               |   | 6.2                                                     |   | $ | 5.81 |   | 973,375 |   | $ | 5.26 |   |

 

The weighted-average grant datefair values of options granted for the years ended December 31, 2001,2000, and 1999 were $2.71, $5.84, and $5.23, respectively.

 

*1998 Outside Directors Stock Bonus Plan_*The Company’s Board of Directors approved the 1998Outside Directors Stock Bonus Plan in April 1998, pursuant to which 25,000shares of the Company’s common stock were reserved for issuance.  Under the terms of the agreement, 1,000bonus shares of common stock will be awarded to each non–employeedirector who is such at the beginning of any regular annual meeting of theCompany’s stockholders while the 1998 Outside Directors Stock Bonus Plan is ineffect and who will continue to serve on the Board of Directors.  Bonus shares are issued in consideration ofservices previously rendered to the Company. At the time bonus shares areissued, the Company recognizes compensation expense equal to the fair value ofthe shares issued. The Company amended the 1998 Outside Directors Stock BonusPlan in March 2001 to increase the number of shares reserved under the Planfrom 25,000 to 50,000.  On a cumulativebasis through December 31, 2001, the Company has issued 25,000 shares of commonstock pursuant to the 1998 Outside Directors Stock Bonus Plan.

 

*Notes Receivable from Officers and Employees (*“*Stock Loan Program*”*)_*The Company maintains aStock Loan Program pursuant to which executive officers and other seniorpersonnel of the Company may borrow from the Company for the purpose ofacquiring common stock of the Company, to pay the exercise price of options andto pay any taxes, including alternative minimum taxes, payable upon theexercise of options or the vesting of restricted stock.  Such borrowings may not exceed $400,000 inany fiscal quarter or $800,000 in the aggregate at any time during the term ofthe Stock Loan Program for all employees. The loans are recourse to theborrower. The interest rate assessed on loans to employees for the purpose ofacquiring stock through the exercise of stock options is determined as of thedate of exercise and is generally considered by the Company to be anappropriate market rate commensurate with the credit quality of the borrower.Interest payments are payable annually in arrears, and are payable as toprincipal no later than five years after the date of the loan. Periodicprincipal repayments are required in an amount equal to 20% of theparticipant’s after-tax bonus.  Aportion of the shares purchased with such loans are pledged to the Company ascollateral for repayment

 

18

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of the loans. The Stock Loan Program was amendedon October 24, 2001 to provide that all loans under the program are forgivenupon a “change of control” of the Company as defined in the 2000 Plan.

 

*2001 Supplemental Executive Bonus Plan_*  On October24, 2001, the Compensation Committee of the Board of Directors adopted the 2001Supplemental Executive Bonus Plan which permits the Committee, in itsdiscretion, to award supplemental bonuses to key executives in an amount up to20% of the executive’s annual bonus.  Nosuch supplemental bonus shall be awarded to an executive unless he or she hasan outstanding loan under the Company’s Stock Loan Program and not in excess ofthe amount of such outstanding loan. The full after-tax amount of any supplemental bonus is required to bepaid to reduce the amount of the executive’s outstanding stock loan.  No supplemental bonuses were awarded during2001 under the 2001 Supplemental Executive Bonus Plan.

 

*Pro Forma Disclosure_*As described in Note A, the Company uses theintrinsic-value method to measure compensation expense associated with thegrants of stock options or awards to employees.  Had the Company used the fair-value method to measurecompensation, reported net income (loss) and basic and diluted net income(loss) per share would have been as follows:

 
|                                |   | **2001**                                      |   | **2000** |   | **1999** |   |
|-------------------------------------|--------|-----------------------------------------------|--------|----------|--------|----------|--------|
|                                |   | **(in thousands, except per share  amounts)** |   |
| Net income (loss)                   |   | $                                             | 2,282  |     | $      | (690     | )      | $ | 2,346 |   |
|                                |   |                                          |   |     |   |     |   |
| Basic net income (loss) per share   |   | $                                             | 0.58   |     | $      | (0.18    | )      | $ | 0.62 |   |
|                                |   |                                          |   |     |   |     |   |
| Diluted net income (loss) per share |   | $                                             | 0.53   |     | $      | (0.18    | )      | $ | 0.53 |   |

 

For purposes of determining theabove disclosure required by SFAS No. 123, the fair value of options on theirgrant date was measured using the Black-Scholes option pricing model. Key assumptionsused to apply this pricing model were as follows:

 
|                                     |   | **2001**    |   | **2000**    |   | **1999**    |   |
|------------------------------------------|--------|-------------|--------|-------------|--------|-------------|--------|
| Weighted-average risk-free interest rate |   | 3.6         | %      | 6.0         | %      | 6.1         | %      |
| Expected life of option grants           |   | 5-10  years |   | 5-10  years |   | 5-10  years |   |
| Expected volatility of stock             |   | 24.1        | %      | 65.3        | %      | 32.4        | %      |

 

The pro forma presentation onlyincludes the effects of grants made subsequent to January 1, 1995.  The pro forma amounts may not be indicativeof the future benefit, if any, to be received by the option holder.

 

**NOTE J. EMPLOYEEBENEFIT PLANS**

 

*Employee Stock Ownership Plan_*In 1993, the Company established an Employee StockOwnership Plan (“ESOP”) for the benefit of all eligible employees. The ESOPinvests in common stock of the Company on behalf of the employees. ESOPcontributions are at the discretion of the Company’s Board of Directors and aredetermined annually. However, it is the Company’s intention to makecontributions sufficient to repay the ESOP’s promissory note on a level-fundingbasis over a 10-year period. The Company measures the expense related to suchcontributions based on the annual average fair value of the stock contributed.The difference between the average fair value of the stock contribution and theoriginal cost of the stock when issued to the ESOP is recorded as additionalpaid-in capital in the year in which the contribution relates. Principalrepayments on the promissory note were $105,000, in 2001, 2000, and 1999.

 

Employees with five or more yearsof service with the Company at the time of termination of employment will befully vested in their benefits under the ESOP. For a participant with fewerthan five years of service at the time of termination, his or her accountbalance will vest at the rate of 20% for each year of employment. Upon theretirement or other termination of an ESOP participant, the shares of commonstock in which he or she is vested, at the option of the participant, may beconverted to cash or distributed. Unvested shares are allocated to theremaining participants. The Company issued 300,000 shares of common stock tothis plan in consideration of a promissory note in the original principalamount of $1,050,000. As of December 31, 2001, the remaining principalbalance of the note is $211,000, which is recorded as a component of deferredcompensation in stockholders’ equity. Since inception of the ESOP, 230,854shares of common stock have been allocated to participant accounts and 69,146shares remain unallocated. The market value of the unallocated shares atDecember 31, 2001 was approximately $450,000.

 

19

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*Savings Plan_*The Company has established a Savings Plancovering substantially all full-time employees, which allows participants tomake contributions by salary deductions pursuant to Section 401(k) of theInternal Revenue Code. The Company matches employee contributions up to amaximum of 2% of the employee’s salary. Both employee and employercontributions are vested immediately. The Company’s contributions to theSavings Plan were $141,000, $128,000 and $111,000 in 2001, 2000 and 1999,respectively.

 

*Supplemental Executive Retirement Plan*_ In 1997, the Company adopted an unfundedSupplemental Executive Retirement Plan (the “SERP”).  The SERP provides certain executives with retirement income benefitsintended to supplement other retirement benefits available to theexecutives.  Benefits under the plan,based on an actuarial equivalent of a life annuity, are based on age, length ofservice and average earnings and vest over 15 years, assuming five years ofservice.  Benefits are payable uponseparation of service.  In 2000, theCompany’s Board of Directors approved an amendment to the SERP pursuant towhich the compensation base on which benefits under the plan are to bedetermined was increased for each participant. An adjustment was recorded atthat time to the required benefit obligation to record retroactively theaffects of the amendment since the inception of the plan.

 

Details of the SERP for the years ended December31, 2001 and 2000 are as follows:

 
|                                                                  |   | **2001**            |   | **2000** |   |
|-----------------------------------------------------------------------|--------|---------------------|--------|----------|--------|
|                                                                  |   | **(in  thousands)** |   |
| **Change in  benefit obligation:**                                    |   |                |   |     |   |
| Benefit obligation, beginning of year                                 |   | $                   | 2,681  |     | $      | 927 |   |
| Service cost                                                          |   | 291                 |   | 254      |   |
| Interest cost                                                         |   | 223                 |   | 175      |   |
| Amendments                                                            |   | —              |   | 1,088    |   |
| Actuarial loss                                                        |   | 221                 |   | 237      |   |
| Benefit obligation, end of year                                       |   | 3,416               |   | 2,681    |   |
|                                                                  |   |                |   |     |   |
| **Funded status and statement of financial position:**                |   |                |   |     |   |
| Fair value of assets, end of year                                     |   | —              |   | —   |   |
| Benefit obligation, end of year                                       |   | 3,416               |   | 2,681    |   |
| Funded status                                                         |   | (3,416              | )      | (2,681   | )      |
| Unrecognized actuarial loss                                           |   | 456                 |   | 253      |   |
| Unrecognized prior service cost                                       |   | 1,156               |   | 1,280    |   |
| Net accrued benefit cost                                              |   | (1,804              | )      | (1,148   | )      |
|                                                                  |   |                |   |     |   |
| Amounts recognized in the statement of financial position consist of: |   |                |   |     |   |
| Accrued benefit liability included in accrued liabilities             |   | (2,327              | )      | (1,614   | )      |
| Intangible assets included in other assets                            |   | 523                 |   | 466      |   |
| Net accrued benefit cost                                              |   | (1,804              | )      | (1,148   | )      |
|                                                                  |   |                |   |     |   |
| **Components of net periodic benefit costs:**                         |   |                |   |     |   |
| Service cost                                                          |   | 291                 |   | 254      |   |
| Interest cost                                                         |   | 223                 |   | 175      |   |
| Amortization of prior service cost                                    |   | 124                 |   | 124      |   |
| Recognized actuarial loss                                             |   | 18                  |   | 3        |   |
| Net periodic benefit cost                                             |   | $                   | 656    |     | $      | 556 |   |

 

20

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|                                             |   | **2001**  |   | **2000**  |   |
|--------------------------------------------------|--------|-----------|--------|-----------|--------|
| **Weighted-average  assumptions:**               |   |      |   |      |   |
| For pension cost and year end benefit obligation |   |      |   |      |   |
| Discount rate                                    |   | 7.00      | %      | 7.00      | %      |
| Compensation increase                            |   | 4.00      | %      | 4.00      | %      |
| Assumed retirement age                           |   | 65  years |   | 65  years |   |

 

**NOTE K.PREFERRED STOCK PURCHASE RIGHTS PLAN**

 

Pursuant to a rights agreementbetween the Company and Fleet National Bank, as rights agent, dated August 3,1993 and amended and restated on September 16, 1999, the Board of Directorsdeclared a dividend on August 3, 1993 of one preferred stock purchase right(“Right”) for each share of the Company’s common stock (the “Shares”)outstanding on or after August 13, 1993. The Right entitles the holder to purchase one one-hundredth of a shareof Series A preferred stock, which fractional share is substantially equivalentto one share of common stock, at an exercise price of $20.  The Rights will not be exercisable ortransferable apart from the common stock until the earlier to occur of 10 daysfollowing a public announcement that a person or affiliated group has acquired15 percent or more of the outstanding common stock (such person or group, an“Acquiring Person”), or 10 business days after an announcement or commencementof a tender offer which would result in a person or group becoming an AcquiringPerson, subject to certain exceptions.  TheRights beneficially owned by the Acquiring Person and its affiliates becomenull and void upon the Rights becoming exercisable.

 

If a person becomes an AcquiringPerson or certain other events occur, each Right entitles the holder, otherthan the Acquiring Person, to purchase common stock (or one one-hundredth of ashare of preferred stock, at the discretion of the Board of Directors) having amarket value of two times the exercise price of the Right.  If the Company is acquired in a merger orother business combination, each exercisable Right entitles the holder, otherthan the Acquiring Person, to purchase common stock of the acquiring companyhaving a market value of two times the exercise price of the Right.

 

At any time after a personbecomes an Acquiring Person and prior to the acquisition by such person of 50%or more of the outstanding common stock, the Board of Directors may direct theCompany to exchange the Rights held by any person other than an AcquiringPerson at an exchange ratio of one share of common stock per Right.  The Rights may be redeemed by the Company,subject to approval by the Board of Directors, for one cent per Right inaccordance with the provisions of the Rights Plan.  The Rights have no voting or dividend privileges.

 

**NOTE L.DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

SFAS No. 107, “Disclosures aboutFair Value of Financial Instruments”, requires the Company to disclose theestimated fair values for its financial instruments. Financial instrumentsinclude items such as loans, interest rate swap contracts, notes payable, andother items as defined in SFAS No. 107.

 

The fair value of a financialinstrument is the amount at which the instrument could be exchanged in acurrent transaction between willing parties, other than in a forced orliquidation sale.

 

Quoted market prices are usedwhen available; otherwise, management estimates fair value based on prices offinancial instruments with similar characteristics or using valuationtechniques such as discounted cash flow models. Valuation techniques involve uncertaintiesand require assumptions and judgments regarding prepayments, credit risk anddiscount rates. Changes in these assumptions will result in different valuationestimates. The fair values presented would not necessarily be realized in animmediate sale, nor are there plans to settle liabilities prior to contractualmaturity. Additionally, SFAS No. 107 allows companies to use a wide range ofvaluation techniques; therefore, it may be difficult to compare the Company’sfair value information to other companies’ fair value information.

 

The following table presents a comparison of thecarrying value and estimated fair value of the Company’s financial instrumentsat December 31, 2001 and 2000:

 

21

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|                                                                             |   | **2001**            |   | **2000**                  |   |
|----------------------------------------------------------------------------------|--------|---------------------|--------|---------------------------|--------|
|                                                                             |   | **Carrying  Value** |   | **Estimated  Fair Value** |   | **Carrying  Value** |   | **Estimated****Fair Value** |   |
|                                                                             |   | **(in  thousands)** |   |
| Financial assets:                                                                |   |                |   |                      |   |   |   |   |   |
| Cash and cash equivalents                                                        |   | $                   | 4,510  |                      | $      | 4,510 |   | $ | 1,713 |   | $ | 1,713 |   |
| Restricted cash                                                                  |   | 29,471              |   | 29,471                    |   | 115,502 |   | 115,502 |   |
| Net investment in leases and notes                                               |   | 397,865             |   | 399,096                   |   | 368,772 |   | 361,548 |   |
| Interest rate swap contracts, included in other assets (Note 1)                  |   | 9                   |   | 9                         |   | — |   | — |   |
| Financial liabilities:                                                           |   |                |   |                      |   |   |   |   |   |
| Notes payable and subordinated debt, net of unamortized original issue  discount |   | 356,791             |   | 369,342                   |   | 424,446 |   | 424,513 |   |
| Interest rate swap contracts (Note 1)                                            |   | 7,230               |   | 7,230                     |   | — |   | 1,749 |   |
|                                                                                  |        |                     |        |                           |        |  |  |  |  |  |  |  |  |

 

----

Note 1:   SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities”, which became effective for the Company onJanuary 1, 2001, requires all derivative instruments to be recorded on thebalance sheet as either assets or liabilities at their estimated fair value.

 

Interest rate swap contractsreflect the marked-to-market valuation of the swaps hedging on-balance sheetdebt obligations of the Company. In addition to the swaps listed above, theCompany has assigned portions of interest rate swap contracts to third partiesin connection with sales of leases and notes receivable (Notes C and E). Theestimated fair value of interest rate swap contracts assigned to third partieswhich are not recorded on the Company’s consolidated balance sheet was aliability of $8,864,000 and $1,236,000 at December 31, 2001 and 2000,respectively.

 

The following methods and assumptionswere used to estimate the fair value of each class of financial instrument:

 

Cash,cash equivalents and restricted cash: For these short-term instruments, thecarrying amount is a reasonable estimate of fair value.

 

Netinvestment in leases and notes: The fair value was estimated by discounting theanticipated future cash flows using current rates applied to similarcontracts.  The fair value of impairedloans is estimated by discounting management’s estimate of future cash flowswith a discount rate commensurate with the risk associated with such assets.

 

Notespayable and subordinated debt: The fair market value of the Company’s seniorand subordinated notes is estimated based on the quoted market prices forsimilar issues or on the current rates offered to the Company for debt ofsimilar maturities.

 

Interestrate swap contracts: The fair value of interest rate swap contracts is based onthe estimated amount due upon termination of the agreements.

 

**NOTE M.  OPERATING SEGMENTS**

 

*General*- The Company has two reportable operating segments:  (i) financing to licensed professionals, and (ii) asset-basedfinancing to commercial and industrial companies.  The Company’s financingagreements with licensed professionals are structured as non-cancelable, full-payoutleases or notes due in installments. Asset-based financing includes revolving lines of credit to commercialand industrial companies in the form of notes receivable collateralized byaccounts receivable, inventory and/or fixed assets.  These two segments employ separate sales forces and market theirproducts to different types of customers. The licensed professional financing segment derives its revenuesprimarily from earnings on fixed-rate leases and notes, whereas revenues fromthe commercial and industrial financing segment are derived predominantly fromoutstanding borrowings under variable-rate notes issued under the lines ofcredit plus miscellaneous commitment and performance-based fees.

 

*FinancialStatement Information* - In its monthly internal managementreports, the Company allocates resources and assesses performance of theoperating segments by monitoring the profit contribution of each segment beforeinterest expense, interest income on cash balances, and income tax provision.  The Company does not allocate corporateoverhead to its asset-based financing segment since substantially all suchoverhead relates to the licensed professional financing segment.

 

A summary of information about the Company’s operations by operating segmentfor the years ended December 31, 2001, 2000, and 1999 is as follows:

 

22

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|                                         |   | **Licensed   Professional   Financing** |   | **Commercial    and   Industrial   Financing** |   | **Total** |   |
|----------------------------------------------|--------|-----------------------------------------|--------|------------------------------------------------|--------|-----------|--------|
|                                         |   | **(in thousands)**                      |   |
| **2001**                                     |   |                                    |   |                                           |   |      |   |
| Earned income on leases and notes            |   | $                                       | 44,047 |                                           | $      | 3,923     |   | $ | 47,970 |   |
| Gain on sales of leases and notes            |   | 14,928                                  |   | —                                         |   | 14,928    |   |
| Provision for losses                         |   | (8,799                                  | )      | (610                                           | )      | (9,409    | )      |
| Selling, general and administrative expenses |   | (20,519                                 | )      | (1,607                                         | )      | (22,126   | )      |
| Net profit contribution                      |   | 29,657                                  |   | 1,706                                          |   | 31,363    |   |
|                                         |   |                                    |   |                                           |   |      |   |
| Total assets                                 |   | 408,484                                 |   | 33,255                                         |   | 441,739   |   |
|                                         |   |                                    |   |                                           |   |      |   |
| **2000**                                     |   |                                    |   |                                           |   |      |   |
| Earned income on leases and notes            |   | 44,113                                  |   | 5,349                                          |   | 49,462    |   |
| Gain on sales of leases and notes            |   | 12,078                                  |   | —                                         |   | 12,078    |   |
| Provision for losses                         |   | (8,528                                  | )      | (690                                           | )      | (9,218    | )      |
| Term securitization costs                    |   | (7,106                                  | )      | —                                         |   | (7,106    | )      |
| Selling, general and administrative expenses |   | (17,913                                 | )      | (1,868                                         | )      | (19,781   | )      |
| Net profit contribution                      |   | 22,644                                  |   | 2,791                                          |   | 25,435    |   |
|                                         |   |                                    |   |                                           |   |      |   |
| Total assets                                 |   | 461,654                                 |   | 34,709                                         |   | 496,363   |   |
|                                         |   |                                    |   |                                           |   |      |   |
| **1999**                                     |   |                                    |   |                                           |   |      |   |
| Earned income on leases and notes            |   | 35,799                                  |   | 4,752                                          |   | 40,551    |   |
| Gain on sales of leases and notes            |   | 4,916                                   |   | —                                         |   | 4,916     |   |
| Provision for losses                         |   | (4,376                                  | )      | (113                                           | )      | (4,489    | )      |
| Selling, general and administrative expenses |   | (16,050                                 | )      | (1,665                                         | )      | (17,715   | )      |
| Net profit contribution                      |   | 20,289                                  |   | 2,974                                          |   | 23,263    |   |
|                                         |   |                                    |   |                                           |   |      |   |
| Total assets                                 |   | 353,915                                 |   | 34,577                                         |   | 388,492   |   |
|                                              |        |                                         |        |                                                |        |           |        |  |  |  |

 

The following reconciles net segment profitcontribution as reported above to total consolidated income before incometaxes:

 
|                            |   | **2001**           |   | **2000** |   | **1999** |   |
|---------------------------------|--------|--------------------|--------|----------|--------|----------|--------|
|                            |   | **(in thousands)** |   |
| Net segment profit contribution |   | $                  | 31,363 |     | $      | 25,435   |   | $ | 23,263 |   |
| Interest expense                |   | (27,872            | )      | (26,222  | )      | (18,903  | )      |
| Interest income                 |   | 1,879              |   | 1,018    |   | 266      |   |
| Income before income taxes      |   | $                  | 5,370  |     | $      | 231      |   | $ | 4,626 |   |

 

*OtherSegment Information* - The Company derives substantially allof its revenues from domestic customers. As of December 31, 2001, no single customer within the licensedprofessional financing segment accounted for greater than 1% of the total ownedand serviced portfolio of financing contracts in that segment.  Within the commercial and industrialasset-based financing segment, no single customer accounted for greater than10% of the total portfolio in that segment. The licensed professional financing segment relies on certain vendors toprovide referrals to the Company, but for the year ended December 31, 2001, noone vendor accounted for greater than 7% of the Company’s lease and loanoriginations.

 

23

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**NOTE N.  SELECTED QUARTERLY FINANCIAL DATA(Unaudited)**

 

Selected quarterly consolidatedfinancial data (unaudited) for the years ended December 31, 2001 and 2000 areas follows:

 
|                                |   | **Three  Months Ended**                       |   |
|-------------------------------------|--------|-----------------------------------------------|--------|
|                                |   | **March 31**                                  |   | **June 30** |   | **September 30** |   | **December 31** |   |
|                                |   | **(in thousands, except per share  amounts)** |   |
| **Year 2001**                       |   |                                          |   |
| Revenues:                           |   |                                          |   |   |   |   |   |   |   |
| Earned income on leases and notes   |   | $                                             | 12,031 |   | $ | 12,416 |   | $ | 12,014 |   | $ | 11,509 |   |
| Gain on sales of leases and notes   |   | 2,644                                         |   | 4,218 |   | 4,305 |   | 3,761 |   |
| Provision for losses                |   | (1,507                                        | )      | (2,553 | ) | (2,752 | ) | (2,597 | ) |
| Net Revenues                        |   | 13,168                                        |   | 14,081 |   | 13,567 |   | 12,673 |   |
|                                |   |                                          |   |   |   |   |   |   |   |
| Operating and Other Expenses:       |   |                                          |   |   |   |   |   |   |   |
| Selling, general and administrative |   | 5,186                                         |   | 6,246 |   | 5,453 |   | 5,241 |   |
| Interest expense (net)              |   | 6,555                                         |   | 7,036 |   | 6,453 |   | 5,949 |   |
|                                |   |                                          |   |   |   |   |   |   |   |
| Income before Income Taxes          |   | 1,427                                         |   | 799 |   | 1,661 |   | 1,483 |   |
| Provision for Income Taxes          |   | 584                                           |   | 322 |   | 660 |   | 588 |   |
| Net Income                          |   | $                                             | 843    |   | $ | 477 |   | $ | 1,001 |   | $ | 895 |   |
|                                |   |                                          |   |   |   |   |   |   |   |
| Basic Net Income per Share          |   | $                                             | 0.21   |   | $ | 0.12 |   | $ | 0.25 |   | $ | 0.23 |   |
| Diluted Net Income per Share        |   | $                                             | 0.20   |   | $ | 0.11 |   | $ | 0.23 |   | $ | 0.21 |   |
|                                |   |                                          |   |   |   |   |   |   |   |   |   |   |   |
| **Year 2000**                       |   |                                          |   |   |   |   |   |   |   |
| Revenues:                           |   |                                          |   |   |   |   |   |   |   |
| Earned income on leases and notes   |   | $                                             | 11,620 |   | $ | 12,356 |   | $ | 12,870 |   | $ | 12,616 |   |
| Gain on sales of leases and notes   |   | 1,154                                         |   | 2,467 |   | 2,149 |   | 6,308 |   |
| Provision for losses                |   | (1,357                                        | )      | (1,839 | ) | (2,202 | ) | (3,820 | ) |
| Net Revenues                        |   | 11,417                                        |   | 12,984 |   | 12,817 |   | 15,104 |   |
|                                |   |                                          |   |   |   |   |   |   |   |
| Operating and Other Expenses:       |   |                                          |   |   |   |   |   |   |   |
| Selling, general and administrative |   | 4,770                                         |   | 5,323 |   | 4,774 |   | 4,914 |   |
| Term securitization costs           |   | —                                        |   | — |   | — |   | 7,106 |   |
| Interest expense (net)              |   | 5,467                                         |   | 6,313 |   | 6,589 |   | 6,835 |   |
|                                |   |                                          |   |   |   |   |   |   |   |
| Income (Loss) before Income Taxes   |   | 1,180                                         |   | 1,348 |   | 1,454 |   | (3,751 | ) |
| Provision for Income Taxes          |   | 487                                           |   | 553 |   | 594 |   | (1,490 | ) |
| Net Income (Loss)                   |   | $                                             | 693    |   | $ | 795 |   | $ | 860 |   | $ | (2,261 | ) |
|                                |   |                                          |   |   |   |   |   |   |   |
| Basic Net Income (Loss) per Share   |   | $                                             | 0.19   |   | $ | 0.20 |   | $ | 0.22 |   | $ | (0.57 | ) |
| Diluted Net Income (Loss) per Share |   | $                                             | 0.16   |   | $ | 0.18 |   | $ | 0.20 |   | $ | (0.57 | ) |
|                                     |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

24

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**INDEPENDENTAUDITORS’ REPORT**

 

To the Board of Directors and Stockholders ofHPSC, Inc.:

 

We have audited the accompanying consolidated balance sheets of HPSC,Inc. and subsidiaries (the “Company”) as of December 31, 2001 and 2000, and therelated consolidated statements of operations, changes in stockholders’ equityand comprehensive income, and cash flows for each of the three years in theperiod ended December 31, 2001. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.

 

We conducted our audits in accordance withauditing standards generally accepted in the United States of America. Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly,in all material respects, the financial position of HPSC, Inc. and subsidiariesas of December 31, 2001 and 2000, and the results of their operations and theircash flows for each of the three years in the period ended December 31, 2001,in conformity with accounting principles generally accepted in the UnitedStates of America.

 

As discussed in Note A to the consolidatedfinancial statements, effective January 1, 2001, the Company adopted theprovisions of Statement of Financial Accounting Standards No. 133, “Accountingfor Derivative Instruments and Hedging Activities”.

 

 

/s/ Deloitte & Touche LLP

Boston, Massachusetts

 

March 18, 2002

 

25

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**MARKET INFORMATION**

 

On May 17, 2000, the Company’s common stock begantrading on the American Stock Exchange (Symbol: “HDR”).  Prior to that date, the Company’s commonstock was traded on the NASDAQ Market (Symbol: “HPSC”). The table below setsforth the representative high and low closing prices for shares of the commonstock of the Company as reported by the American Stock Exchange and the NASDAQNational Market System for the fiscal years 2001 and 2000:

 
| **2001 Fiscal Year** |   | **High** |   | **Low** |   | **2000  Fiscal Year** |   | **High**      |   | **Low** |   |
|----------------------|--------|----------|--------|---------|--------|-----------------------|--------|---------------|--------|---------|--------|
| First Quarter        |   | $        | 6.75   |    | $      | 6.00                  |   | First Quarter |   | $       | 10.00  |   | $ | 7.13 |   |
| Second Quarter       |   | 8.80     |   | 6.50    |   | Second Quarter        |   | 9.63          |   | 7.00    |   |
| Third Quarter        |   | 8.45     |   | 6.80    |   | Third Quarter         |   | 8.75          |   | 6.63    |   |
| Fourth Quarter       |   | 8.15     |   | 6.50    |   | Fourth Quarter        |   | 6.93          |   | 5.30    |   |
|                      |        |          |        |         |        |                       |        |               |        |         |        |  |  |  |  |  |  |  |

 

The foregoing quotations represent prices betweendealers, and do not include retail markups, markdowns, or commissions.

 

**Holders**

 
| **Title of Class**                     |   | **Approximate Number of Record   Holders (as of February 26, 2002** |   |
|----------------------------------------|--------|---------------------------------------------------------------------|--------|
| Common Stock, par value $.01 per share |   | 86  (1)                                                        |   |

 

**Dividends**

 

The Company has never paid any dividends andanticipates that, for the foreseeable future, its earnings will be retained foruse in its business.

 

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(1)   This numberdoes not reflect beneficial ownership of shares held in “nominee” or “streetname.”

 

26

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**SELECTED FINANCIAL DATA**

 
|                                    |   | **Year Ended**                                      |   |
|-----------------------------------------|--------|-----------------------------------------------------|--------|
|                                    |   | **Dec. 31,  2001**                                  |   | **Dec. 31,  2000(4)** |   | **Dec. 31,  1999** |   | **Dec.31,  1998** |   | **Dec. 31,  1997** |   |
|                                    |   | **(in thousands, except share and per share data)** |   |
| **Statement  of Operations Data**       |   |                                                |   |   |   |   |   |   |   |   |   |
|                                    |   |                                                |   |   |   |   |   |   |   |   |   |
| Revenues:                               |   |                                                |   |   |   |   |   |   |   |   |   |
| Earned income on  leases and notes      |   | $                                                   | 47,970 |   | $ | 49,462 |   | $ | 40,551 |   | $ | 33,258 |   | $ | 23,691 |   |
| Gain on sales of  leases and notes      |   | 14,928                                              |   | 12,078 |   | 4,916 |   | 4,906 |   | 3,123 |   |
| Provision for  losses                   |   | (9,409                                              | )      | (9,218 | ) | (4,489 | ) | (4,201 | ) | (2,194 | ) |
| Net Revenues                            |   | 53,489                                              |   | 52,322 |   | 40,978 |   | 33,963 |   | 24,620 |   |
| Net Income                              |   | $                                                   | 3,216  |   | $ | 87 |   | $ | 2,719 |   | $ | 1,976 |   | $ | 1,121 |   |
| Net Income per  Share – Basic(1)   |   | $                                                   | 0.81   |   | $ | 0.02 |   | $ | 0.72 |   | $ | 0.53 |   | $ | 0.30 |   |
| – Diluted(1)                       |   | $                                                   | 0.74   |   | $ | 0.02 |   | $ | 0.61 |   | $ | 0.47 |   | $ | 0.26 |   |
| Shares Used to  Compute – Basic(1) |   | 3,965,378                                           |   | 3,879,496 |   | 3,766,684 |   | 3,719,026 |   | 3,732,576 |   |
| Net Income per  Share – Diluted(1) |   | 4,319,673                                           |   | 4,292,650 |   | 4,436,476 |   | 4,194,556 |   | 4,315,370 |   |

 
|                           |   | **Dec. 31,  2001** |   | **Dec. 31,  2000** |   | **Dec. 31,  1999** |   | **Dec. 31,  1998** |   | **Dec. 31,  1997** |   |
|--------------------------------|--------|--------------------|--------|--------------------|--------|--------------------|--------|--------------------|--------|--------------------|--------|
|                           |   | **(in thousands)** |   |
| **Balance  Sheet Data**        |   |               |   |               |   |               |   |               |   |               |   |
|                           |   |               |   |               |   |               |   |               |   |               |   |
| Cash and cash  equivalents     |   | $                  | 4,510  |               | $      | 1,713              |   | $                  | 1,356  |               | $      | 4,583 |   | $ | 2,137 |   |
| Restricted  cash(2)            |   | 29,471             |   | 115,502            |   | 14,924             |   | 9,588              |   | 7,000              |   |
| Lease and notes  receivable(3) |   | 489,245            |   | 455,742            |   | 447,263            |   | 345,271            |   | 263,582            |   |
| Unearned income                |   | 104,741            |   | 98,089             |   | 94,228             |   | 73,019             |   | 53,868             |   |
| Total Assets                   |   | 441,739            |   | 496,363            |   | 388,492            |   | 300,308            |   | 232,626            |   |
| Revolving credit  borrowings   |   | 52,000             |   | 49,000             |   | 70,000             |   | 49,000             |   | 39,000             |   |
| Senior notes,  net of discount |   | 284,806            |   | 355,461            |   | 227,445            |   | 174,541            |   | 123,952            |   |
| Subordinated  debt             |   | 19,985             |   | 19,985             |   | 20,000             |   | 20,000             |   | 20,000             |   |
| Stockholders’  Equity     |   | 39,656             |   | 40,790             |   | 40,318             |   | 37,575             |   | 35,174             |   |
|                                |        |                    |        |                    |        |                    |        |                    |        |                    |        |  |  |  |  |  |  |

 

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1)             Net income per share for all periods presented conformto the provisions of Statement of Financial Accounting Standards No. 128,“Earnings per Share”.

 

2)             Restricted cash at December 31, 2000 includes$20,284,000 for securitization servicing arrangements and $95,218,000 inprefunding provided to the Company pursuant to the ER 2000-1 termsecuritization. 

 

3)             Leases and notes receivable include the Company’sretained interest in leases and notes sold under sales and securitizationagreements.

 

4)             Net income and basic and diluted net income per sharefor the year ended December 31, 2000 include one-time charges of $7,106,000associated with completing the ER 2000-1 term securitization.

 

27

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**MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION**

** **

**CRITICAL ACCOUNTING POLICIES**

 

The consolidated financial statements are prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation offinancial statements requires management to make certain estimates andassumptions that affect the reported amounts of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. The Company believes that, of itssignificant accounting policies (as discussed in Note A to the notes toconsolidated financial statements), the following may involve a higher degreeof judgment or complexity:

 

*Allowancefor Losses*-  Theallowance for losses is established through a charge to the provision forlosses. Provisions are made to reserve for estimated future losses arising fromthe Company’s portfolio of lease and note financing contracts. Each reportingperiod, the Company evaluates the adequacy of the allowance for losses andrecords an adjustment to the provision for losses to restore the allowance todesignated levels. To evaluate the adequacy of the allowance for losses, theCompany utilizes certain estimates and assumptions. Management bases theseestimates and assumptions on historical experience and on various other factorsthat they believe to be reasonable under the circumstances.  Each delinquent customer account iscarefully evaluated based on specific criteria, such as delinquency status, valueof equipment or other collateral, credit bureau scores, financial condition ofany guarantors, and recent payment performance of the obligor. In addition, theCompany may factor in other considerations such as historical charge-off rates,delinquency trends and general economic conditions. Applying differentestimates or assumptions could potentially produce materially different resultsfrom those reported by the Company.

 

*Salesof Financing Contracts*- TheCompany periodically sells leases and notes in its securitization facilitiesand to various banks. Gains on sales of leases and notes are recognized in theconsolidated statements of operations when the Company relinquishes control ofthe transferred financing contracts in accordance with SFAS No. 140. TheCompany typically provides credit enhancement through the establishment of aretained interest in the financing contracts sold. Recorded gains orlosses upon the sale of financing contracts depends, in part, on the fair valueof the retained interest. The Company must also continually evaluate itsretained interest in financing contracts sold for impairment to its fair value.These routine fair value calculations require management to utilize certainestimates and assumptions regarding anticipated performance of the financingcontracts sold, such as credit risk, prepayments, and discount rates.Management bases its estimates and assumptions on historical portfolioperformance. There is no guarantee that historical financing contract portfolioperformance will be indicative of future performance.

 

**RESULTS OF OPERATIONS**

** **

***Fiscal Years EndedDecember 31, 2001 and December 31, 2000***

 

The Company’s owned net investment in leases and notesincreased by 8% to $397,865,000 at December 31, 2001 from $368,772,000 atDecember 31, 2000.  The total managedportfolio of financing contracts, which includes both leases and notes owned bythe Company as well as those sold to others and serviced by the Company,increased to $649,275,000 at December 31, 2001 from $557,498,000 at December31, 2000, an increase of 16%.

 

Earned income from leases and notes for 2001 was$47,970,000 as compared to $49,462,000 for 2000. The 3% decrease was primarilydue to increased asset sale activity during the first three quarters of fiscal2001 compared to the equivalent periods in 2000, lower-average implicit rates,along with lower-average credit line utilization by ACFC’s borrowers. This waspartially offset by an increase in the Company’s financing contractoriginations in its core licensed professional financing segment. Financingcontract originations for fiscal 2001 increased approximately 6% to$263,411,000 from $248,874,000 for 2000. Earned income on leases and notes is afunction of both the implicit rates as well as the average level of owned netinvestment in leases and notes for the year. Weighted-average implicit rates onthe Company’s financing portfolio were 11.7% and 12.1% at December 31, 2001 and2000, respectively. Earned income, which is net of amortization of initialdirect costs, is recognized over the life of the leases and notes using theeffective interest method.

 

Pre-tax gains from sales of leases and notes increasedto $14,928,000 in 2001 compared to $12,078,000 in 2000, an increase of 24%. Theincrease of $2,850,000 was due to higher levels of lease and loan contractssold during the current year, which contributed $180,000 to the increase, andimproved market conditions for securitizations, which contributed $2,670,000 tothe increase.  For the twelve monthsended December 31, 2001, the Company sold a portion of its beneficial interestin leases and notes totaling $145,811,000 compared to $143,690,000 for the sameperiod in 2000.

 

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Interest expense, net of interest income on cashbalances, was $25,993,000 (54.2% of earned income) in 2001, a 3% increase overthe comparable total of $25,204,000 (51.0% of earned income) for 2000.  The increase in net interest expense waslargely due to net interest charges incurred in the first quarter of 2001associated with the $95,000,000 provided to the Company from the ER 2000-1prefunding arrangement, as well as increased amortization of deferred debtorigination costs resulting from completing the term securitizationtransaction. Based on average outstanding borrowings, the Company’s cost offunds, including its Senior Subordinated Notes, was 6.5% and 6.8% at December31, 2001 and 2000, respectively.

 

Net financing margin (earned income less net interestexpense) for fiscal year 2001 was $21,977,000 (45.8% of earned income) ascompared to $24,258,000 (49.0% of earned income) for 2000, a 10% decrease.  The decrease in amount and percentage waslargely due to net interest charges incurred in the first quarter of 2001associated with the $95,000,000 provided to the Company from the ER 2000-1prefunding arrangement, as well as increased amortization of deferred debtorigination costs resulting from completing the term securitizationtransaction.

 

The provision for losses for the year ended December31, 2001 was $9,409,000 compared to $9,218,000 for the same period in 2000, a2% increase. The increase resulted in part from higher levels of new financingsin 2001. In addition, the Company has experienced higher charge-offs in itsportfolio of financing contracts. In reviewing these facts as well as thepotential impact of general economic conditions, the Company has increased itsallowance for losses. At December 31, 2001, the Company’s allowance for losseswas $15,359,000 (3.9% of owned net investment in leases and notes) compared to$14,170,000 (3.8% of owned net investment in leases and notes) at December 31,2000.  Total consolidated netcharge-offs were $8,220,000 in 2001 compared to $4,198,000 in 2000.  The increase in 2001 was due in part to thebankruptcy of an equipment vendor and the resulting customer lawsuits over thevendor’s products financed by the Company. The Company agreed to settle therelated lawsuit in June 2001 and subsequently charged-off approximately$1,800,000 representing the remaining balances due on the disputed customers’accounts.

 

Selling, general and administrative expenses forfiscal year 2001 increased 12% to $22,126,000 compared to $19,781,000 for2000.  The increase in the current yearresulted in part from increased bank service charges as well as higher legaland collection related expenses arising from increased collection activities.In addition, the Company paid $819,000 during the second quarter of 2001 tosettle the lawsuit referred to in the previous paragraph.  The Company does not anticipate incurringadditional costs or legal fees related to this matter.

 

The prior year results were negatively affected byone-time charges of $7,106,000 associated with completing the $527,000,000 termsecuritization transaction (Note C). These charges fell into two primary categories.  The first, which totaled approximately$3,118,000, were non-cash charges associated with structural and ratedifferences upon the transfer of previously sold leases and notes from the Company’sBravo and Capital commercial paper conduit facilities into the termsecuritization facility as well as fair value impairment adjustments on theCompany’s related retained interest. The second category of expense, which totaled approximately $3,988,000,related to costs incurred to break existing interest rate swap contractshedging the terminated borrowings under the Bravo and Capital Facilities.

 

Income before income taxes for fiscal year 2001 was$5,370,000 compared to $231,000 for 2000. The Company’s effective income taxrate for the year ended December 31, 2001 was 40.1% compared to 62.3% for theyear 2000. The effective tax rate for 2000was significantly higher due to the effect of comparing an equivalent level ofpermanent non-deductible expenses to a significantly lower pre-tax income forthe year. Net income for the year ended December 31, 2001 was $3,216,000($0.74 diluted net income per share) compared to $87,000 ($0.02 diluted netincome per share) for fiscal year 2000. The increase in net income in 2001compared to 2000 was due, in part, to an increase in gains on sales of leasesand notes and as a result of the one-time charges incurred in 2000 inconnection with the completion of the ER 2000-1 term securitization. These werepartially offset by slightly lower earned income on leases and notes andincreased selling, general, and administrative costs in 2001 as compared to theprior year.

 

Net profit contribution, representing income beforeinterest and taxes, from the licensed professional financing segment was$29,657,000 for the year ended December 31, 2001 compared to $22,644,000 for the comparable period in2000, a 31% increase.  The increase wasdue in part from increased gains on sales of leases and notes of $14,928,000 in2001 from $12,078,000 in 2000 resulting from higher levels of lease and loancontracts sold during the current year as well as improved market conditionsfor securitizations. This was offset by higher selling, general andadministrative expenses of $20,519,000 in 2001 compared to $17,913,000 in 2000,due in part to increased interest rate swap breakage costs, higher bank servicecharges, as well as higher legal and collection related expenses. In addition,year 2000 results were significantly affected by one-time charges of $7,106,000incurred in connection with completing the Company’s term securitizationtransaction.

 

29

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Net profit contribution (income before interest andtaxes) from the commercial and industrial asset-based financing segment was$1,706,000 for the year ended December 31, 2001 compared to $2,791,000 for thecomparable period in 2000, a 39% decrease. The decrease was due to lower earnedinterest and fee income on notes of $3,923,000 in 2001 compared to $5,349,000in 2000 resulting from generally lower average credit line utilization byACFC’s borrowers, offset by lower selling, general and administrative expensesof $1,607,000 in 2001 compared to $1,868,000 in 2000.

 

At both December 31, 2001 and 2000, the Company had$119,000,000 of customer applications approved but which had not yet resultedin a completed financing transaction. Not all approved applications will result in a completed financingtransaction with the Company.

 

***Fiscal Years EndedDecember 31, 2000 and December 31, 1999***

 

The Company’s owned net investment in leases and notesincreased 1% to $368,772,000 at December 31, 2000 from $364,848,000 at December31, 1999.  The total managed portfolioof financing contracts, including both leases and notes owned by the Company aswell as those sold to others but serviced by the Company, increased to$557,498,000 at December 31, 2000 from $450,392,000 at December 31, 1999, anincrease of 24%.

 

Earned income from leases and notes for 2000 was$49,462,000 (including $5,349,000 from ACFC) as compared to $40,551,000(including $4,752,000 from ACFC) for 1999. This 22% increase was primarily due to increases in the net investmentin leases and notes from 1999 to 2000, which resulted, in part, from an increasein the Company’s financing contract originations.  Financing contract originations for fiscal year 2000 increased10% to $248,874,000 (including $7,300,000 in ACFC line of credit originations)from $226,534,000 (including $18,167,000 in ACFC line of credit originations)for 1999.  Earned income on leases andnotes is primarily a function of the interest on the Company’s owned netinvestment in leases and notes.  Earnedincome, which is net of amortization of initial direct costs, is recognizedusing the effective interest method over the life of the leases and notes.  Pre-tax gains from sales of leases and notesincreased to $12,078,000 in 2000 compared to $4,916,000 in 1999, a 146%increase.  The increase was due tohigher levels of sales activity in 2000 as compared to 1999.  For the twelve months ended December 31,2000, the Company sold a portion of its beneficial interest in leases and notestotaling $143,690,000 compared to $54,930,000 for the same period in 1999.

 

Interest expense, net of interest income on cashbalances, was $25,204,000 (51.0% of earned income) in 2000, compared to$18,637,000 (46.0% of earned income) for 1999, an increase of 35%.  The increase in net interest expense wasprimarily due to a 34% increase in debt levels from 1999 to 2000 resulting fromincreased borrowings to finance the Company’s increased financing contractoriginations. In addition, net interest expense increased in 2000 due to higherdebt levels attributable to the prefunding arrangement provided to the Companythrough the term securitization in December 2000.  The increase in percentage of earned income was due to higheraverage borrowing costs in 2000 compared to 1999.

 

Net financing margin (earned income less net interestexpense) for fiscal year 2000 was $24,258,000 (49.0% of earned income) ascompared to $21,914,000 (54.0% of earned income) for 1999.  The increase in amount was generally due tohigher earnings on a higher balance of earning assets.  The decrease in percentage of earned incomewas due to higher interest rate debt during 2000 compared to 1999.

 

The provision for losses for the year ended December31, 2000 was $9,218,000 compared to $4,489,000 for the same period in 1999, a105% increase.  The increase resulted inpart from higher levels of new financings in 2000.  In addition, the Company has experienced higher delinquencies andcharge-offs in its portfolio of financing contracts.  In reviewing these facts as well as the potential impact ofgeneral economic conditions, the Company has increased its allowance for losslevels accordingly.  A primary cause forthe increase in delinquencies, the provision for losses, and the allowance forlosses was the bankruptcy of an equipment vendor and resulting customer disputesover the products financed by the Company, and not any identifiable weakness inthe Company’s underwriting or collections standards. If delinquencies relatedto this vendor situation were excluded, the Company’s financing contractdelinquencies at December 31, 2000 would have been comparable, on a percentagebasis, to the delinquencies at the end of the prior year.  During 2000, the Company’s commerciallending subsidiary also experienced a loss on a loan resulting from an obligorbankruptcy.  The account had an originalcarrying value of approximately $900,000, of which $400,000 has beencharged-off and the balance reserved. At December 31, 2000, the Company’s allowance for losses was $14,170,000(3.8% of net investment in leases and notes) as compared to $9,150,000 (2.5% ofnet investment in leases and notes) at December 31, 1999.  Total consolidated net charge-offs were$4,198,000 in 2000 compared to $2,689,000 in 1999.

 

Selling, general and administrative expenses forfiscal year 2000 increased 12% to $19,781,000 compared to $17,715,000 for1999.  The increase resulted in partfrom higher legal and collection agency related expenses arising out of higherdelinquency 

 

30

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levels, higher liquidity and bank charges associated with the Company’scommercial paper securitization facilities, as well as increased systems andadministrative costs required to support higher levels of owned and servicedassets.

 

In December 2000, the Company incurred one-timecharges of $7,106,000 associated with completing the $527,000,000 termsecuritization transaction (Note C). These charges fell into two primarycategories.  The first, which totaledapproximately $3,118,000, were non-cash charges associated with structural andrate differences upon the transfer of previously sold leases and notes from theCompany’s Bravo and Capital commercial paper conduit facilities into the termsecuritization facility as well as fair value impairment issues on theCompany’s related retained interest. The second category of expense, which totaled approximately $3,988,000,related to costs incurred to break existing interest rate swap contractshedging the terminated borrowings from the Bravo and Capital Facilities.

 

Income before income taxes for fiscal year 2000 was$231,000 compared to $4,626,000 for 1999. The Company’s effective income tax rate for the year ended December 31,2000 was 62.3% compared to 41.2% for the year 1999.  The effective tax rate for2000 was significantly higher due to the effect of comparing an equivalentlevel of permanent non-deductible expenses to a significantly lower pre-taxincome for the year.  Net incomefor the year ended December 31, 2000 was $87,000 ($0.02 diluted net income pershare) compared to $2,719,000 ($0.61 diluted net income per share) for thecomparable 1999 period.  The decrease innet income in 2000 compared to 1999 was due substantially to the one-timecharges incurred in connection with the Company’s term securitizationtransaction in December 2000.

 

Although the one-time charges incurred in December2000 resulted in lower earnings for the year, the term securitization facilityhas provided the Company with increased liquidity at reduced rates, whichshould allow the Company to continue its planned growth.  In addition, the Company has effectivelymatch-funded significant portions of its portfolio at favorable rates.

 

Net profit contribution, representing income beforeinterest and taxes, from the licensed professional financing segment was$22,644,000 for the year ended December 31, 2000 compared to $20,289,000 for the comparable period in1999, a 12% increase.  The increase wasdue to an increase in earned income on leases and notes to $44,113,000 in 2000compared to $35,799,000 in 1999 andhigher gains on sales of leases and notes of $12,078,000 in 2000 from$4,916,000 in 1999, offset by onetime charges of $7,106,000 associated withcompleting the term securitization in December 2000, an increase in theprovision for losses in 2000 to $8,528,000 from $4,376,000 in the prior year, andan increase in selling, general and administrative expenses to $17,913,000 in2000 compared to $16,050,000 in 1999.

 

Net profit contribution (income before interest andtaxes) from the commercial and industrial financing segment was $2,791,000 forthe year ended December 31, 2000 compared to $2,974,000 for the comparableperiod in 1999, a 6% decrease.  Thedecrease was due to an increase in selling, general and administrative expensesto $1,868,000 in 2000 compared to $1,665,000 in 1999 and an increase in theprovision for losses in 2000 to $690,000 from $113,000 in 1999, offset by anincrease in earned interest and fee income on notes to $5,349,000 in 2000compared to $4,752,000 in 1999.

 

At December 31, 2000, the Company had $119,000,000 ofcustomer applications approved but which had not yet resulted in a completedtransaction, compared to $104,000,000 of customer applications at December 31,1999.  Not all approved applicationswill result in a completed financing transaction with the Company.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

The Company’s financing activities require substantialamounts of capital, and its ability to originate new financing contractsdepends on the availability of cash and credit.  The Company currently has access to credit under its RevolvingLoan Agreement, the ER 2000-1 term securitization, its Bravo revolvingsecuritization facility, as well as its senior notes to savings banks.  The Company also obtains cash from sales ofits financing contracts under its securitization facilities and throughcollections generated from its lease and note portfolio. Substantially all ofthe assets of the Company have been pledged to HPSC’s lenders as security underits various credit arrangements. The pledged assets include all of theCompany’s rights to receive payments under its financing contracts and thecollateral security granted to the Company by the borrowers under thosefinancing contracts. Borrowings under the Revolving Loan Agreement andborrowings under senior notes to savings banks are full recourse obligations ofthe Company.  All securitizationagreements are limited recourse obligations.

 

The Company’s financing strategy is to warehousetemporarily new financing contracts through borrowings under its Revolving LoanAgreement. The warehouse borrowings are repaid with the proceeds obtained fromother permanent financings as well as from cash flows generated from thefinancing contracts. The Company usually obtains such fixed-rate permanentfinancing within 30 to 60 days of original contract activation.  Depending on market conditions, the Companymay also periodically finance large pools of its financing contracts throughthe issuance of a term securitization. Such permanent financing may be in theform of 

 

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a loan to the Company or in the form of a sale in which a majority ofthe value of the financing contract is removed from the Company’s balancesheet. In the case of a sale, the Company is typically obligated to provideadditional credit enhancement to credit providers.  Credit enhancement may be provided in various forms, includingthrough a retained interest in the assets sold, the establishment of restrictedcash accounts, or through third-party financial guarantees. ACFC’s asset-basednotes receivable are financed through borrowings under both the Revolving LoanAgreement as well as through borrowings under the ER 2000-1 termsecuritization.

 

**Cash and Cash Flow Activities**

At December 31, 2001, the Company had a total of$33,981,000 in cash, cash equivalents and restricted cash as compared to$117,215,000 at the end of 2000. A significant portion of this cash wasrestricted pursuant to various securitization agreements.  Components of restricted cash at December31, 2001 and 2000 were as follows:

 
|                                                     |   | **2001**           |   | **2000** |   |
|----------------------------------------------------------|--------|--------------------|--------|----------|--------|
|                                                     |   | **(in thousands)** |   |
| Cash collections- Bravo                                  |   | $                  | 4,358  |     | $      | 5,738 |   |
| Cash collections- ER 2000-1 LLC I                        |   | 3,386              |   | —   |   |
| Cash collections- ER 2000-1 LLC II                       |   | 9,103              |   | 4,675    |   |
| Prefunding arrangement- ER 2000-1                        |   | —             |   | 95,218   |   |
| Capitalized interest- ER 2000-1                          |   | —             |   | 1,049    |   |
| Amounts required for initial interest payment- ER 2000-1 |   | —             |   | 2,735    |   |
| Cash escrow- ER 2000-1 swap agreement                    |   | 1,000              |   | 1,002    |   |
| Cash reserves- ER 2000-1                                 |   | 11,624             |   | 5,085    |   |
| Total                                                    |   | $                  | 29,471 |     | $      | 115,502 |   |

 

Cash and cash equivalents were $4,510,000 at December31, 2001 compared to $1,713,000 at December 31, 2000.  The following is a description of the significant activitiesaffecting the Company’s cash and cash equivalents for the years 2001 and 2000.

 

Cash provided by operating activities for the yearended December 31, 2001 was $8,598,000 compared to $8,075,000 for the prioryear. The significant changes in cash provided by operating activities were netincome of $3,216,000 in 2001 compared to $87,000 in 2000, adjusted for increasednon-cash gains on sales of leases and notes receivable of $14,928,000 in 2001compared to $12,078,000 in 2000, increased deferred income taxes in 2001 of$2,067,000 compared to a decrease of $207,000 in 2000, and an increase inaccounts payable and accrued liabilities of $2,014,000 compared to a decreaseof $1,060,000 in the prior year. The increase in net income from 2000 to 2001was additionally affected by swap breakage costs of $636,000 in 2001 comparedto $3,988,000 in 2000, and non-cash structural and retained interest impairmentcosts of $3,118,000 recognized upon transfer of assets from the commercialpaper conduits into the term securitization in 2000.

 

Cash used in investing activities was $151,753,000 forthe year ended December 31, 2001 compared to $100,640,000 for the prior year.The significant components of cash used in investing activities were anincrease in cash used to originate new leases and notes receivables of$258,782,000 in 2001 compared to $251,206,000 in 2000, offset by portfolioreceipts of $79,115,000 in 2001 and $89,402,000 in 2000, as well as proceedsfrom sales of leases and notes receivable of $26,145,000 in the current year ascontrasted to $50,818,000 for the comparable 2000 period. In addition, net cashused in investing activities for 2000 was reduced by $9,804,000 as a result ofnet proceeds received from the negotiated reacquisition and subsequent resaleof leases and notes receivable into the term securitization.

 

Cash provided by financing activities was $145,952,000for the year ended December 31, 2001 compared to $92,922,000 for the sameperiod in 2000. The major components of cash provided by financing activitiesinclude proceeds from the issuance of commercial paper conduit senior notes of$153,608,000 in 2001 as contrasted to $173,519,000 in 2000, proceeds from thesale of the Class E and Class F term securitization notes in 2001 of $4,592,000compared to $352,645,000 from the issuance of the Class A - D termsecuritization notes in 2000, and warehouse revolving credit facility netproceeds of $3,000,000 in 2001 compared to net repayments of $21,000,000 in theprior year. These were offset by commercial paper conduit senior noterepayments in 2001 of $51,209,000 compared to $307,589,000 in 2000, andrepayments of term securitization notes of $49,279,000 in the current yearcompared to none in the prior year. The proceeds received from the termsecuritization notes were used to retire amounts outstanding under both theCompany’s commercial paper conduit facilities and warehouse revolving creditborrowings. In addition, $95,218,000 of initial proceeds under the termsecuritization were provided to the Company under the prefunding arrangementestablished in that securitization. For the year ended December 31, 2001, restrictedcash decreased $86,031,000 compared to an increase of $100,578,000 for the sameperiod in 2000, primarily as a result of the usage of the prefunded cash during2001.

 

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**Warehouse Financing**

*RevolvingLoan Agreement*_ In May2000, the Company executed the Fourth Amended and Restated Revolving LoanAgreement with Fleet National Bank as the Agent, providing the Company withavailability up to $90,000,000 through May 2001.  In May 2001, the Company signed a Third Amendment to theFourth Amended and Restated Credit Agreement with Fleet National Bank (the “Revolving Loan Agreement” or “Revolver”),providing availability to the Company of up to $83,500,000, upon substantiallythe same terms and conditions, through May 2002. The Company utilizesborrowings under its Revolving Loan Agreement primarily to warehousetemporarily new financing contracts until permanent fixed-rate financing isavailable as well as to finance a portion of the lending activity generated byits ACFC subsidiary. Under the Revolver, a base portion of the outstandingborrowings is at variable rates of 75 to 125 basis points above the primelending rate, while the remainder is at 225 to 275 basis points above LIBORrates. The level of spread to be paid above the base rate and LIBOR rates isdependent upon the Company’s balance sheet leverage as well as compliance withcertain performance covenants. At December 31, 2001, the Company had$52,000,000 outstanding under the Revolver and $31,500,000 available forborrowing, subject to borrowing base limitations.  The Revolver is not currently hedged, and is, therefore, exposedto upward movements in interest rates. Certain covenants governing theCompany’s tangible net worth, interest coverage, and leverage ratio wereamended in March 2001, effective retroactive to December 31, 2000, primarily topermit the costs incurred by the Company in connection with completing its ER2000-1 term securitization as well as from the adoption of SFAS No. 133. As ofDecember 31, 2001, the Company was in compliance with all of its amendedcovenant requirements and expects to continue to be in compliance for thebalance of the current Revolver term. 

 

The Company intends to renew its Revolver beyond May2002 and is currently in discussion with various participating banks, however,there can be no assurance it will be able to do so. Although, historically, theCompany has been successful in renewing its annual Revolver facility at levelsand costs acceptable to the Company, the Company has reason to believe that oneor more of the banks lending to the Company may not renew their commitment. Ifthis occurs, the Company will seek to replace any bank not renewing. There canbe no assurance that the Company will be able to replace any non-renewingbanks. Thus, it is possible that the Company will have a reduced amount or noamount available under its Revolver after expiration of the current RevolverAgreement in May 2002. If the Revolver Agreement is not renewed or replaced, theoutstanding balance under the current Revolver must be repaid in quarterlyinstallments over a twelve month period with the first installment due on June30, 2002. If the Revolver is terminated or reduced below specific levels, theCompany may be in default under its Bravo facility and the Company may beunable to conduct its business or may be unable to conduct its business atcurrent levels.

 

**Permanent Financing**

*BravoFacility*_  In March2000, the Company, along with its wholly-owned, special-purpose subsidiary,Bravo Funding LLC (“Bravo”), signed an amended revolving creditfacility (the “Bravo Facility”) structured and guaranteed by MBIA,Inc.  At December 31, 2001 and 2000, theBravo Facility provided the Company with available borrowings up to $385,000,000and $397,500,000, respectively. Under the terms of the Bravo Facility, theCompany contributes certain of its financing contracts to Bravo which, in turn,either pledges or sells its interests in these assets to a commercial paperconduit entity. Credit enhancement is provided to the noteholders throughfinancial guarantees provided by MBIA as to the payment of principal andinterest on the notes.  The Company’scurrent financing strategy is to either pledge or sell eligible financingcontracts to Bravo on a monthly basis, thereby minimizing its exposure tofluctuating interest rates in the Revolver warehousing facility.  Financing contracts pledged by Bravo, alongwith the associated debt to the conduit entity, are included on the Company’sconsolidated balance sheet.  In the caseof financing contracts sold by Bravo, the assets and associated debt areremoved from the Company’s consolidated balance sheet. Additional creditenhancement is provided to investors through the creation of a retained interestin the financing contracts sold. Risk of loss to the Company is limited to theextent of the Company’s retained interest and residual values in the financingcontracts sold. Bravo incurs interest at variable rates in the commercial papermarket and enters into interest rate swap contracts to assure fixed-ratefunding.  Monthly settlements ofprincipal and interest payments on the notes are made from the collections onthe Bravo financing contract portfolio. The Company is the servicer of theBravo portfolio, subject to meeting certain performance covenants.  In December 2000, the Company repaid asubstantial portion of outstanding borrowings in the Bravo Facility withproceeds received from the issuance of the Equipment Receivables 2000-1 termsecuritization notes.

 

At December 31, 2001, the Company had a total of$126,468,000 outstanding under the loan portion of the Bravo Facility and, inconnection therewith, had interest rate swap contracts outstanding with a totalnotional value of $123,827,000. The total amount outstanding under the salesportion of the Bravo Facility was $74,388,000 at December 31, 2001 and, inconnection therewith, the Company had outstanding interest rate swap contractsassigned to third parties with a notional value of $71,902,000. The Bravo securitization agreements containrestrictive covenants governing, among other things, tangible net worth,leverage requirements, interest coverage, capital expenditures, as well ascertain portfolio performance guidelines such as delinquency and default levelsof the financing contracts. During each quarter in fiscal year 2001, theCompany obtained a waiver from its lenders for non-compliance with its tangible net worth, interest coverage, andleverage requirements. This non-compliance resulted primarily from costsincurred by the Company in connection with completing the ER 2000-1 termsecuritization in December 2000 as well as from the adoption of SFAS No. 133. Asof December 31, 2001, the Company was not in compliance with its tangible net worthand leverage covenants but has received a waiver from its lenders. The Companywas in compliance with all other requirements of the Bravo securitization. TheCompany currently intends to continue to utilize the Bravo Facility for aportion of its permanent financing requirements. Since the Company’s lendershave opted at this time not to amend the tangible net worth and leveragecovenants, the Company intends to continue to seek to obtain similar waivers inthe future, as necessary, but there can be no assurance that it will be able todo so.  Under the terms of the Company’sdebt agreements, a default condition triggered by non-compliance with its BravoFacility could result in a cross default where the Company would also be indefault with its other funding sources. Such a situation, although unlikely,could significantly affect the Company’s ability to continue to raiseadditional liquidity which would likely result in a substantial curtailment ofthe Company’s current growth and operations. In addition, under suchcircumstances, the 

 

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Company could be replaced as the servicer of the portfolio.

 

                The Bravocommercial paper conduit facility expires in June 2003. The required annualliquidity facility expires in June 2002. The Company expects that it will beable to renew the liquidity facility and may seek to expand the size of thefacility. It is possible, however, the banks providing liquidity under thefacility will not extend their commitment. If annual liquidity commitments arenot renewed, the facility will be limited to the then existing outstandings andwill not be available to the Company to provide future liquidity. If theliquidity banks terminate or reduce their commitment, the Company will seek toreplace the terminated or reduced amount, but there can be no assurance thatthe Company will be able to do so. If the Bravo facility is unavailable, theCompany may be unable to conduct its business or may be unable to conduct itsbusiness at current levels. 

 

*EquipmentReceivables 2000-1*_ In December 2000, the Company completed a $527,106,000 private placementterm securitization, referred to as the Equipment Receivables 2000-1.  HPSC, along with subsidiaries ACFC, Bravo,and HPSC Capital Funding, Inc. (a special-purpose entity subsequentlyterminated in June 2001), transferred certain lease and note contracts to newlyformed special-purpose entities, ER 2000-1 LLC I and ER 2000-1 LLC II. ER2000-1 LLC I and ER 2000-1 LLC II issued notes to finance the purchase of, andloan against, the collateral consisting of the leases and notes transferredfrom HPSC, ACFC, Bravo and Capital.  ER2000-1 LLC I was formed to meet the criteria of a qualifying, unconsolidated,special-purpose entity within the meaning of SFAS Nos. 125 and 140, while ER2000-1 LLC II was formed to be a consolidated, special-purpose entity. Thecarrying value of the financing contracts and associated debt transferred to ER2000-1 LLC I were removed from the Company’s consolidated balance sheet. Creditenhancement is provided to investors through the creation of a retainedinterest in the financing contracts sold. Risk of loss to the Company islimited to the extent of the Company’s retained interest and residual values inthe contracts sold. Financing contracts transferred to ER 2000-1 LLC II werepledged as collateral on the notes, with the carrying value of the financingcontracts and associated debt included in the Company’s consolidated balancesheet. The proceeds from the notes were used to retire senior notes and otherobligations outstanding in both the Bravo and Capital Facilities as well as topay down amounts outstanding under the Revolver warehousing facility.

 

The securitization further provided for initialproceeds of $95,218,000 to be prefunded to ER 2000-1 LLC I and ER 2000-1 LLC IIfor the sole purpose of acquiring additional financing contracts from theCompany.  The prefunding period expiredin March 2001, at which time approximately $3,800,000 remained unused and wastreated as a prepayment of principal on the notes.The ER 2000-1 securitization agreement also provided for$1,049,000 of initial proceeds to be placed in a restricted cash account toservice interest requirements to the noteholders on the prefunded debt outstandingduring the prefunding period.  Inaddition, initial proceeds of $2,735,000 were deposited in the restricted cashcollection account to service the interest requirements on the ER 2000-1 notesfor the initial interest accrual period ending in January 2001. At the time of entering into the interest rateswap contracts, the Company deposited $1,000,000 into an interest bearing, cashescrow account as collateral on the swap contracts. The Company providedadditional credit enhancement to the ER 2000-1 noteholders through the creationof both a cash reserve account and a residual payment account. Pursuant to theterms of the ER 2000-1 securitization agreements, certain excess cash flowsgenerated by the portfolio are deposited to the cash reserve account orresidual payment account, up to agreed-upon limits. These restricted cashaccounts are available to fund monthly interest and principal payments on theER 2000-1 notes in the event of deficiencies from the monthly collections.  At December 31, 2001 and 2000, the balancein these restricted cash reserve accounts was $11,624,000 and $5,085,000,respectively. The Company may also provide additional credit enhancementthrough the substitution of new leases and notes for leases and notespreviously contributed to the securitization, up to certain defined limits.

 

ER 2000-1 entered into interest rate swap contracts asa hedge against interest rate risk related to its variable-rate obligations onthe Class A and Class B-1 notes. The interest rate swap contracts have theeffect of converting the Company’s interest payments from a variable-rate to afixed-rate, thereby locking in spreads on the Company’s financing portfolio. AtDecember 31, 2001, ER 2000-1 LLC I had a total of $212,602,000 outstandingrelated to sales of financing contracts and, in connection with the amountsfinanced through the issuance of Class A and Class B-1 variable-rate notes, hadinterest rate swap contracts assigned to third parties with a total notionalvalue of $190,082,000. At December 31, 2001, ER 2000-1 LLC II had total debtoutstanding, net of unamortized original issue discount, with a remainingprincipal balance of $146,779,000 and, in connection with the amounts financedthrough the issuance of Class A and Class B-1 variable-rate notes, had interestrate swap contracts outstanding with a total notional value of $132,091,000.

 

The Company is the servicer ofthe portfolio, subject to continuing to meet certain covenants.  Monthly payments of principal and interest onthe ER 2000-1 notes are made from regularly scheduled collections generatedfrom the lease and note portfolio. Under certain circumstances, the Company may be obligated to advance itsown funds for amounts due on the notes in the event an obligor fails to remit apayment when due. The Company is reimbursed for such advances from availablefunds upon the subsequent collection from the obligor. Credit enhancement isprovided through the structuring of several classes of notes, which are rankedfor purposes of determining priority of payment. Under the terms of the variousdebt agreements, an event of default for non-compliance by the Company with itscovenants may result in an immediate acceleration of all principal amountsoutstanding under all classes of notes. In the unlikely event of such anoccurrence, the Company’s ability to continue to raise additional liquiditycould be adversely affected, which would likely result in a substantialcurtailment of the Company’s current growth and operations. In addition, theCompany could be replaced as the servicer of the portfolio.

 

The Company may periodically continue to utilize termsecuritizations in the future to finance portions of its financing contracts. The timing and the ability of the Company tocomplete such financings will depend, to a large extent, on market conditionsfor such transactions, but there can be no assurance that the Company will beable to do so or that it will be able to do so in a timely fashion.

 

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*VariousBanks_*The Companyperiodically enters into secured, fixed-rate, fixed-term loan agreements withvarious banks for purposes of financing its operations. The loans are generallysubject to certain recourse and performance covenants. At December 31, 2001, theCompany had outstanding borrowings under such loan agreements of approximately$11,559,000 with annual interest rates ranged from 6.5% to 8.0%. These loansare included on the Company’s consolidated balance sheet as senior notes. In1995 and 1996, the Company had also sold certain financing contracts to variousbanks. These sales agreements are subject to covenants that, among othermatters, may require the Company to repurchase the financing contracts soldand/or make payments when due. At December 31, 2001, the total outstandingbalance of these sold off-balance sheet transactions was $579,000.

 

*SeniorSubordinated Notes_* In March 1997, the Company issued  $20,000,000 of unsecured senior subordinatednotes due in 2007 (“SeniorSubordinated Notes”) bearing interestat a fixed-rate of 11% (the “Note Offering”). The Company received approximately $18,300,000 in net proceeds from theNote Offering and used such proceeds to repay amounts outstanding under theRevolver.  The Senior Subordinated Notes are redeemable at the option of theCompany, in whole or in part, other than through the operation of a sinkingfund, after April 1, 2002 at established redemption prices plus accrued butunpaid interest to the date of repurchase. Beginning July 1, 2002, the Company is required to redeem, throughsinking-fund payments, on January 1, April 1, July 1, and October 1 of eachyear, a portion of the aggregate principal amount of the Senior SubordinatedNotes at a redemption price of $1,000,000 plus accrued but unpaid interest tothe redemption date.  The Companyexpects to be able to meet its payment obligations under its SeniorSubordinated Notes, but there can be no assurance that it will be able to doso.

 

**Summary of totalcontractual obligations**

A summary of the Company’s totalcontractual payment obligations, which includes long-term debt provided throughits warehouse and permanent portfolio financings, as well as future minimumlease payments under its non-cancelable operating leases for its officelocations, is as follows at December 31, 2001:

 

|                |   | **Long-Term   Debt** |    | **Operating   Leases** |   | **Total** |   |
|---------------------|--------|----------------------|---------|------------------------|--------|-----------|--------|
|                |   | **(in thousands)**   |    |
| 2002                |   | $                    | 133,581 |                   | $      | 774       |   | $ | 134,355 |   |
| 2003                |   | 64,478               |    | 562                    |   | 65,040    |   |
| 2004                |   | 57,370               |    | 264                    |   | 57,634    |   |
| 2005                |   | 46,055               |    | —                 |   | 46,055    |   |
| 2006                |   | 34,104               |    | —                 |   | 34,104    |   |
| 2007 and thereafter |   | 22,183               |    | —                 |   | 22,183    |   |
| Total               |   | $                    | 357,771 |                   | $      | 1,600     |   | $ | 359,371 |   |

 

**Stock Repurchase Program**

In December 2000, the Board of Directors approved anincrease to the stock repurchase program whereby the Company may repurchase upto an additional 250,000 shares of the Company’s common stock subject tomaximum dollar limitations as set forth under the Company’s Revolving LoanAgreement and Senior Subordinated Note financings. Based on current marketvalues at December 31, 2001 and the limitations as set forth in its debtagreements, the Company may repurchase up to an additional 166,000 shares ofits common stock. No time limit has been established for the repurchaseprogram. The Company expects to use the repurchased stock to meet the current andfuture requirements of its employee stock plans.  During 2001, the Company repurchased 69,288 shares of its commonstock for approximately $495,000.

 

Management believes that the Company’s sources ofliquidity, including availability of credit under the Revolver Agreement, theBravo Facility, the ER 2000-1 securitization, the Senior Subordinated Notes,and loans from various savings banks, along with cash obtained from the salesof its financing contracts and from internally generated revenues, are adequateto meet current obligations and carry on current operations.  In order to finance its future operations,the Company may seek to raise additional equity and will seek to renew and/orobtain new liquidity facilities. The Company expects that it will be able toobtain additional capital at competitive rates, but there can be no assuranceit will be able to do so.

 

**QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

In the normal course of its business, the Company issubject to a variety of risks, including market risk associated with interestrate movements.  Interest rate exposuresexist between the time a transaction with a customer is approved and whenpermanent, fixed-rate financing is secured. The Company does not hold or issuefinancial instruments for trading purposes.

 

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The Company temporarily warehouses its new fixed-ratefinancing contracts through variable-rate revolving credit borrowings untilpermanent fixed-rate financing is obtained through its securitizationfacilities.  The Company is exposed tointerest rate changes between the time a new financing contract is approved andthe time the permanent, fixed-rate financing is completed, thereby locking infinancing spreads.  To mitigate thisexposure, the Company generally obtains such permanent financing within 60 daysof the activation of a new financing contract. The Company believes it will be able to continue to utilize thisoperating strategy. The Company further manages its exposure to interest raterisk by entering into interest rate swap contracts as a hedge againstvariable-rate interest incurred through its commercial paper securitizationfacility as well as its Class A and Class B-1 term securitization notes. Theseswap agreements have the effect of converting the Company’s debt from itssecuritizations from a variable-rate to a fixed-rate. At December 31, 2001, thenet marked-to-market value of interest rate swap contracts hedging on-balancesheet debt obligations was a liability of $7,221,000. Assuming a hypothetical10% reduction in interest rates from current weighted-average swap rates atDecember 31, 2001, the marked-to-market valuation of these swap agreementswould have been approximately $11,628,000.

 

The Company’s portfolio of financing contractsoriginated in its licensed professional financing segment are fixed-rate,non-cancelable, full payout leases and notes. Changes in current marketinterest rates result in unrealized gains or losses in the fair value of the Company’sfixed-rate assets and fixed-rate debt. In a rising interest rate environment,fixed-rate assets lose market value whereas fixed-rate liabilities gain marketvalue. The opposite can be said in a declining rate environment. The fair valueof fixed-rate financial assets and liabilities can be determined by discountingassociated cashflows at market rates currently available for instruments withsimilar risk characteristics and maturities. Sensitivity analysis can beapplied to determine the positive or negative affect market risk exposures mayhave on the fair value of the Company’s financial assets and liabilities. Thefollowing table summarizes the carrying value and estimated fair value of theCompany’s fixed-rate assets and liabilities at December 31, 2001. The tablealso demonstrates the degree of sensitivity to the fair value of the Company’sfixed-rate financial assets and liabilities assuming a hypothetical 10% adversechange from actual rates:

 

|                                            |   | **Carrying Value** |    | **Fair Value** |   | **10% change** |   |
|-------------------------------------------------|--------|--------------------|---------|----------------|--------|----------------|--------|
|                                            |   | **(in thousands)** |    |
| Fixed-rate leases and notes due in installments |   | $                  | 338,233 |           | $      | 339,464        |   | $ | 330,202 |   |
| Fixed-rate debt                                 |   | 304,791            |    | 317,342        |   | 309,434        |   |
|                                                 |        |                    |         |                |        |                |        |  |  |  |

 

The Company’s variable-rate assets primarily consistof commercial and industrial asset-based revolving loans originated by ACFC.The carrying value of variable-rate assets and liabilities approximates currentfair values. Sensitivity analysis can be used to determine the positive ornegative affect on the Company’s interest income and expenses due to changes inmarket interest rates, as summarized as follows at December 31, 2001:

 

|                            |   | **Carrying Value** |   | **Fair Value** |   | **+/-Change to   interest assuming  +/-10% change  from actual rates** |   |
|---------------------------------|--------|--------------------|--------|----------------|--------|------------------------------------------------------------------------|--------|
|                            |   | **(in thousands)** |   |
| Variable-rate notes  receivable |   | $                  | 35,002 |           | $      | 35,002                                                                 |   | $ | +/-431 |   |
| Variable-rate debt              |   | 52,000             |   | 52,000         |   | +/-340                                                                 |   |
|                                 |        |                    |        |                |        |                                                                        |        |  |  |  |

 

For additional information about the Company’sfinancial instruments, see Note L in the notes to consolidated financialstatements.

 

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**FORWARD-LOOKING STATEMENTS**

 

This Annual Report contains forward-looking statementswithin the meaning of Section 27A of the Securities Act.  Discussions containing such forward-lookingstatements may be found in the material set forth under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” aswell as within the Annual Report generally. When used in this Annual Report, the words “believes,” “anticipates,”“expects,” “plans,” “intends,” “estimates,” “continue,” “may,” or “will” (orthe negative of such words) and similar expressions are intended to identifyforward-looking statements. Such statements are subject to a number of risksand uncertainties including, but not limited to, the following:  the Company’s dependence on maintaining andincreasing funding sources; restrictive covenants in funding documents; paymentrestrictions and default risks in asset securitization transactions to whichthe Company is a party; customer credit risks; competition for customers andfor capital funding at favorable rates relative to the capital costs of theCompany’s competitors; changes in healthcare payment policies; interest raterisk; the risk that the Company may not be able to realize the residual valueon financed equipment at the end of its lease term; interest rate hedgecontract risks; risks associated with the sale of certain receivable pools bythe Company; dependence on sales representatives and the current managementteam; and fluctuations in quarterly operating results. The Company’s filingswith the Securities and Exchange Commission, including its Annual Report onForm 10-K for the year ended December 31, 2001 to be filed on or before March31, 2002, contain additional information concerning such risk factors.  Actual results in the future could differmaterially from those described in the forward-looking statements as a resultof the risk factors set forth above, the risk factors described in the AnnualReport on Form 10-K, and the matters set forth in this Annual Report generally.  HPSC cautions the reader, however, that suchlist of risk factors may not be exhaustive. HPSC undertakes no obligation torelease publicly the result of any revisions to these forward-lookingstatements that may be made to reflect any future events or circumstances.

 

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| **OFFICERS**                     | **DIRECTORS**                           | **AUDITORS**                                                                                                                                                                                                                                                                                                                      |
|----------------------------------|-----------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
| **John W. Everets**              | **John W. Everets (3)**                 | Deloitte & Touche LLP                                                                                                                                                                                                                                                                                                         |
| Chairman                         | Chairman                                | 200 Berkeley Street                                                                                                                                                                                                                                                                                                               |
| Chief  Executive Officer         | Chief Executive Officer                 | Boston, Massachusetts  02116                                                                                                                                                                                                                                                                                                 |
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
|                             | **Raymond R. Doherty (3)**              | **COUNSEL**                                                                                                                                                                                                                                                                                                                       |
| **Raymond R. Doherty**           | President                               |                                                                                                                                                                                                                                                                                                                              |
| President                        | Chief Operating Officer                 | Hill & Barlow                                                                                                                                                                                                                                                                                                                 |
| Chief  Operating Officer         |                                    | One International Place                                                                                                                                                                                                                                                                                                           |
|                             | **J. Kermit Birchfield, Jr. (1)(2)(3)** | Boston, Massachusetts  02110                                                                                                                                                                                                                                                                                                 |
|                             | Chairman                                |                                                                                                                                                                                                                                                                                                                              |
| **Rene Lefebvre**                | Displaytech, Inc.                       | **TRANSFER AGENT**                                                                                                                                                                                                                                                                                                                |
| Senior  Executive Vice President |                                    |                                                                                                                                                                                                                                                                                                                              |
| Treasurer                        | **Dollie Cole (1)(2)**                  | Equiserve Trust Company                                                                                                                                                                                                                                                                                                           |
| Chief  Financial Officer         | Chairperson                             | P.O. Box 43010                                                                                                                                                                                                                                                                                                                    |
|                             | Dollie Cole Corporation                 | Providence, RI. 02940-3068                                                                                                                                                                                                                                                                                                        |
|                             |                                    | Shareholder Inquiries:                                                                                                                                                                                                                                                                                                            |
|                             | **Samuel P. Cooley (1)(2)(3)**          | (781) 575-3400                                                                                                                                                                                                                                                                                                                    |
|                             | Retired                                 | www.equiserve.com                                                                                                                                                                                                                                                                                                                 |
|                             | Former Executive Vice President,        |                                                                                                                                                                                                                                                                                                                              |
|                             | Shawmut National Corp.                  | **10-K**                                                                                                                                                                                                                                                                                                                          |
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
|                             | **Thomas M. McDougal, DDS (2)**         | HPSC’s Annual Report on Form                                                                                                                                                                                                                                                                                                 |
|                             | Practicing Dentist                      | 10-K is available to stockholders without charge by  writing to:                                                                                                                                                                                                                                                                  |
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
|                             | **Lowell P. Weicker, Jr. (1)(2)**       |                                                                                                                                                                                                                                                                                                                              |
|                             | Former Governor and                     | Investor Relations Department                                                                                                                                                                                                                                                                                                     |
|                             | and U.S. Senator from Connecticut       | HPSC, Inc                                                                                                                                                                                                                                                                                                                         |
|                             |                                    | 60 State Street, Suite 3520                                                                                                                                                                                                                                                                                                       |
|                             |                                    | Boston, Massachusetts  02109                                                                                                                                                                                                                                                                                                 |
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
|                             |                                    | E-mail address:                                                                                                                                                                                                                                                                                                                   |
|                             |                                    | hpsc@hpsc.com                                                                                                                                                                                                                                                                                                                     |
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
|                             |                                    | Internet web site:                                                                                                                                                                                                                                                                                                                |
|                             |                                    | www.hpsc.com                                                                                                                                                                                                                                                                                                                      |
|                             |                                    |                                                                                                                                                                                                                                                                                                                              |
|                             |                                    | HPSC’s Annual Report on Form 10-K is also available  from the Securities and Exchange Commission (the “SEC”) via the Internet. The  SEC maintains a web site containing reports, proxy and information  statements, and other information regarding registrants who file with the  SEC. The address of the SEC is: |
|                             |                                    | www.sec.gov                                                                                                                                                                                                                                                                                                                       |

* *

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*(1)  Member, Compensation Committee*

*(2)  Member, Audit Committee*

*(3)  Member, Executive Committee*

 

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