**Exhibit13.1**

 

To Our Stockholders:

 

2002 was a signature year for HPSC, Inc.  Buoyed by the strength of the healthcare industry, one of theonly expanding sectors of the economy, we generated a record amount of newfinancing contracts.

 

Today, healthcare spending accounts for around 15% of our country’sgross domestic product. Demographic change in the U.S. is the primary factorcontributing to investment by medical professionals in a wide range oftechnology and office equipment.  The“Baby Boom” generation continues to age — every 8 seconds, another Americanturns 50!  This generation expects anddemands the most advanced healthcare services. Manufacturers of medical technology are responding to this demand withnew equipment such as lasers for plastic surgeons, new less-invasive diagnostictools for internists and digital x-rays for dentists.  The strength of this medical technology market enabled HPSC togrow along with our customers, meeting their needs for financing withcompetitive rates and high quality customer service.

 

HPSC generated a record volume of new originations in 2002:  $311 million, up some 18% from lastyear.  We achieved these results througha focused and disciplined approach to our market.  We improved our outreach to manufacturers of medical technologyand we increased our business in virtually all regions of the country and allsegments of the market that we finance. We added 122 new companies to ourexisting 2,176 vendors, an impressive 6% increase.

 

The Company showed strong bottom-line results in 2002: net income was$4.3 million, or $1.00 per fully diluted share, up from $2.4 million, or $0.55per fully diluted share in 2001.  Basicearnings per share were $1.07 in 2002, compared to $0.60 in 2001.  Net revenues increased by 3%, to $55.3million in 2002 from $53.5 million in 2001.   The gross owned and managed leases and notes receivables, which are animportant measure of our growth rate, rose from $806 million at the end of 2001to $935 million as of December 31, 2002, a 16% climb. Over the past five years,the combined average annual growth rate of the portfolio has been approximately25%, a remarkable rate of increase. Lastly, unearned income — which is incomethat we will recognize in future quarters and thus a sign of our continuedgrowth — reached $118 million at the end of 2002, a 12% increase from $105million at the end of the prior year.

----

 

We want you to know that we have fully resolved the employeedefalcation that we discovered in May of 2002 at our subsidiary, ACFC.  The unfortunate incident affected only asmall portion of our nearly billion-dollar portfolio, but necessitated arestatement of certain prior financial statements.  We are confident that by handling the matter forthrightly we havepreserved our company’s well-deserved reputation for integrity.

 

Where do we go from here? It is our goal to continue to pursuegrowth.  We will market our products andservices aggressively but will apply our conservative, high standards ofunderwriting.  Our strategy is to captureeven more repeat customers — already about 35% of our total originations.  We have attained a strong market presencewith the dental profession and ten other specialties that we will strive toenhance.  We also will continue toexpand our financing of sales and purchases of medical practices.  In this way, we will aid the transition ofone generation of medical professionals to the next, cementing strongrelationships with future customers.  Asalways, we will continuously monitor credit quality to manage our portfoliomost effectively and maintain high credit ratings, which are critical to ourborrowings.

 

We are especially proud to have added Richard D. Field to our board ofdirectors this year.  Dick bringsexceptional experience in consumer and commercial banking operations, havingmost recently served as Senior Executive Vice President of the Bank of NewYork. He also was Chairman of the U.S. Board of Directors of MasterCardInternational from 1992 to 1997, and served as a member of its Executive Committee.  He is one of the founders of LendingTree.comand also serves as a financial advisor to Epigen, Inc., a biopharmaceuticalventure, giving him insights into the healthcare arena.  We welcome Dick to our company.

 

We appreciate your support in the past year and look forward to theyear ahead.

 

Sincerely,

 

 

 

John W. Everets,

Chairman and Chief Executive Officer

March, 2003

 

----

 

**HPSC, Inc. and SubsidiariesCONSOLIDATED  BALANCE  SHEETS**

 

*(in thousands, except per share andshare amounts)*

 
|                                                                                                                       |   | **December 31,** |    |
|----------------------------------------------------------------------------------------------------------------------------|--------|------------------|---------|
|                                                                                                                       |   | **2002**         |    | **2001** |   |
|                                                                                                                       |   |             |    |   |   |
| **ASSETS**                                                                                                                 |   |             |    |   |   |
| Cash and cash equivalents                                                                                                  |   | $                | 51      |   | $ | 698 |   |
| Restricted cash- Servicing under securitization  agreements                                                                |   | 29,633           |    | 28,786 |   |
| Investment in leases and notes:                                                                                            |   |             |    |   |   |
| Lease contracts and notes receivable due in installments                                                                   |   | 494,159          |    | 428,463 |   |
| Notes receivable                                                                                                           |   | 21,052           |    | 34,133 |   |
| Retained interest in leases and notes sold                                                                                 |   | 46,299           |    | 25,780 |   |
| Estimated residual value of equipment at end of lease  term                                                                |   | 25,573           |    | 24,113 |   |
| Deferred origination costs                                                                                                 |   | 10,048           |    | 9,658 |   |
| Less: Unearned income                                                                                                      |   | (118,043         | )       | (104,741 | ) |
| Security deposits                                                                                                          |   | (4,154           | )       | (5,051 | ) |
| Allowance for losses                                                                                                       |   | (16,900          | )       | (15,359 | ) |
| Total net investment in leases and notes                                                                                   |   | 458,034          |    | 396,996 |   |
|                                                                                                                       |   |             |    |   |   |
| Other assets                                                                                                               |   | 9,424            |    | 9,893 |   |
| Total Assets                                                                                                               |   | $                | 497,142 |   | $ | 436,373 |   |
|                                                                                                                       |   |             |    |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                              |   |             |    |   |   |
| Revolving credit borrowings                                                                                                |   | $                | 43,437  |   | $ | 52,000 |   |
| Senior notes, net of discount                                                                                              |   | 344,867          |    | 284,806 |   |
| Subordinated debt                                                                                                          |   | 17,960           |    | 19,985 |   |
| Accounts payable and accrued liabilities                                                                                   |   | 30,664           |    | 26,594 |   |
| Accrued interest                                                                                                           |   | 1,681            |    | 1,659 |   |
| Interest rate swap contracts                                                                                               |   | 9,406            |    | 7,230 |   |
| Deferred income taxes                                                                                                      |   | 9,286            |    | 7,318 |   |
| Total Liabilities                                                                                                          |   | 457,301          |    | 399,592 |   |
|                                                                                                                       |   |             |    |   |   |
| Commitments and Contingencies  (Note F)                                                                               |   |             |    |   |   |
|                                                                                                                       |   |             |    |   |   |
| Stockholders’   Equity:                                                                                          |   |             |    |   |   |
| Preferred stock, $1.00 par value; authorized, 5,000,000  shares; none issued and outstanding                               |   | —           |    | — |   |
| Common stock, $.01 par value; 15,000,000 shares  authorized; issued, 4,817,705 shares in 2002 and 4,779,530 shares in 2001 |   | 48               |    | 48 |   |
| Additional paid-in capital                                                                                                 |   | 15,232           |    | 14,867 |   |
| Retained earnings                                                                                                          |   | 35,941           |    | 31,595 |   |
|                                                                                                                       |   |             |    |   |   |
| Less: Treasury stock, at cost; 685,951 shares in 2002  and 615,765 shares in 2001                                          |   | (4,863           | )       | (4,325 | ) |
| Accumulated other comprehensive loss, net of tax                                                                           |   | (5,711           | )       | (4,348 | ) |
| Deferred compensation                                                                                                      |   | (106             | )       | (305 | ) |
| Notes receivable from officers and employees                                                                               |   | (700             | )       | (751 | ) |
| Total Stockholders’ Equity                                                                                            |   | 39,841           |    | 36,781 |   |
| Total Liabilities and Stockholders’ Equity                                                                            |   | $                | 497,142 |   | $ | 436,373 |   |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

1

----

 

**HPSC, Inc. and SubsidiariesCONSOLIDATED  STATEMENTS  OF OPERATIONS**

 

*(in thousands, except per share andshare amounts)*

 
|                                                        |   | **Year Ended December 31,** |   |
|-------------------------------------------------------------|--------|-----------------------------|--------|
|                                                        |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                                        |   |                        |   |   |   |   |   |
| Revenues:                                                   |   |                        |   |   |   |   |   |
| Earned income on leases and notes                           |   | $                           | 50,954 |   | $ | 47,970 |   | $ | 49,462 |   |
| Gain on sales of leases and notes, net                      |   | 15,804                      |   | 14,928 |   | 12,078 |   |
| Provision for losses                                        |   | (11,448                     | )      | (9,409 | ) | (9,218 | ) |
| Net Revenues                                                |   | 55,310                      |   | 53,489 |   | 52,322 |   |
|                                                        |   |                        |   |   |   |   |   |
| Expenses:                                                   |   |                        |   |   |   |   |   |
| Selling, general and administrative                         |   | 22,280                      |   | 22,126 |   | 19,781 |   |
| Term securitization costs                                   |   | —                      |   | — |   | 7,106 |   |
| Loss from employee defalcation                              |   | 448                         |   | 1,379 |   | 1,361 |   |
| Interest expense                                            |   | 25,773                      |   | 27,872 |   | 26,222 |   |
| Interest income                                             |   | (428                        | )      | (1,879 | ) | (1,018 | ) |
|                                                        |   |                        |   |   |   |   |   |
| Income (Loss) before Income Taxes                           |   | 7,237                       |   | 3,991 |   | (1,130 | ) |
|                                                        |   |                        |   |   |   |   |   |
| Provision (Benefit) for Income Taxes                        |   | 2,891                       |   | 1,612 |   | (391 | ) |
|                                                        |   |                        |   |   |   |   |   |
| Net Income (Loss)                                           |   | $                           | 4,346  |   | $ | 2,379 |   | $ | (739 | ) |
|                                                        |   |                        |   |   |   |   |   |
| Basic Net Income (Loss) per Share                           |   | $                           | 1.07   |   | $ | 0.60 |   | $ | (0.19 | ) |
|                                                        |   |                        |   |   |   |   |   |
| Shares Used to Compute Basic Net Income (Loss) per  Share   |   | 4,064,404                   |   | 3,965,378 |   | 3,879,496 |   |
|                                                        |   |                        |   |   |   |   |   |
| Diluted Net Income (Loss) per Share                         |   | $                           | 1.00   |   | $ | 0.55 |   | $ | (0.19 | ) |
|                                                        |   |                        |   |   |   |   |   |
| Shares Used to Compute Diluted Net Income (Loss) per  Share |   | 4,339,846                   |   | 4,319,673 |   | 3,879,496 |   |

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

2

----

 

**HPSC, Inc. and SubsidiariesCONSOLIDATED  STATEMENTS  OF CHANGES  IN  STOCKHOLDERS’  EQUITY ANDCOMPREHENSIVE INCOME**

 

*(in thousands, except share amounts)*

 
|                                                                                   |   | **Common Stock** |   | **Additional  Paid-In****Capital** |   | **Retained  Earnings** |   | **Treasury  Stock** |   | **Accumulated  Other  Comprehensive  Income (Loss),  net of tax** |   | **Deferred  Compensation** |   | **Notes  Receivable  from  Officers and  Employees** |   | **Total Stockholders’ Equity** |   |
|----------------------------------------------------------------------------------------|--------|------------------|--------|------------------------------------|--------|------------------------|--------|---------------------|--------|-------------------------------------------------------------------|--------|----------------------------|--------|------------------------------------------------------|--------|-------------------------------------|--------|
| **Shares**                                                                             |   | **Amount**       |
|                                                                                   |   |             |   |                               |   |                   |   |                |   |                                                              |   |                       |   |                                                 |   |                                |   |   |   |
| Balance at January 1,  2000                                                       |   | 4,699,530        |   | $                                  | 47     |                   | $      | 14,119              |   | $                                                                 | 29,955 |                       | $      | (3,611                                               | )      | $                                   | — |   | $ | (1,008 | ) | $ | (396 | ) | $ | 39,106 |   |
| Net Income                                                                             |   | —           |   | —                             |   | —                 |   | (739                | )      | —                                                            |   | —                     |   | —                                               |   | —                              |   | (739 | ) |
| 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,  net of tax benefit                                         |   | 6,500            |   | —                             |   | 36                     |   | —              |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 36 |   |
| Balance at December 31,  2000                                                     |   | 4,713,030        |   | 47                                 |   | 14,364                 |   | 29,216              |   | (3,830                                                            | )      | —                     |   | (635                                                 | )      | (410                                | )      | 38,752 |   |
| Net Income                                                                             |   | —           |   | —                             |   | —                 |   | 2,379               |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 2,379 |   |
| 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                                                               |   | —           |   | —                             |   | —                 |   | —              |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | (1,969 | ) |
|                                                                                   |   |             |   |                               |   |                   |   |                |   |                                                              |   |                       |   |                                                 |   |                                |   |   |   |
| 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,  net of tax benefit                                         |   | 60,500           |   | 1                                  |   | 325                    |   | —              |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 326 |   |
| Balance at December 31, 2001                                                           |   | 4,779,530        |   | 48                                 |   | 14,867                 |   | 31,595              |   | (4,325                                                            | )      | (4,348                     | )      | (305                                                 | )      | (751                                | )      | 36,781 |   |
| Net Income                                                                             |   | —           |   | —                             |   | —                 |   | 4,346               |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 4,346 |   |
| Net realized 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 $859)   |   | —           |   | —                             |   | —                 |   | —              |   | —                                                            |   | (1,327                     | )      | —                                               |   | —                              |   | (1,327 | ) |
| Total Comprehensive loss                                                               |   | —           |   | —                             |   | —                 |   | —              |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 2,983 |   |
|                                                                                   |   |             |   |                               |   |                   |   |                |   |                                                              |   |                       |   |                                                 |   |                                |   |   |   |
| Purchase of Treasury Stock                                                             |   | —           |   | —                             |   | —                 |   | —              |   | (538                                                              | )      | —                     |   | —                                               |   | —                              |   | (538 | ) |
| Restricted Stock Compensation                                                          |   | —           |   | —                             |   | —                 |   | —              |   | —                                                            |   | —                     |   | 94                                                   |   | —                              |   | 94 |   |
| ESOP Compensation                                                                      |   | —           |   | —                             |   | 153                    |   | —              |   | —                                                            |   | —                     |   | 105                                                  |   | —                              |   | 258 |   |
| Notes Receivable from  Officers and Employees                                          |   | —           |   | —                             |   | —                 |   | —              |   | —                                                            |   | —                     |   | —                                               |   | 51                                  |   | 51 |   |
| Stock Bonus Awards                                                                     |   | 6,000            |   | —                             |   | 49                     |   | —              |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 49 |   |
| Exercise of Stock Options,  net of tax benefit                                         |   | 32,175           |   | —                             |   | 163                    |   | —              |   | —                                                            |   | —                     |   | —                                               |   | —                              |   | 163 |   |
| Balance at December 31, 2002                                                           |   | 4,817,705        |   | $                                  | 48     |                   | $      | 15,232              |   | $                                                                 | 35,941 |                       | $      | (4,863                                               | )      | $                                   | (5,711 | ) | $ | (106 | ) | $ | (700 | ) | $ | 39,841 |   |

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

3

----

 

**HPSC, Inc. and SubsidiariesCONSOLIDATED  STATEMENTS  OF CASH  FLOWS**

 

*(in thousands)*

 
|                                                                                                                                       |   | **Year Ended December 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                                                                       |   | **2002**                    |       | **2001** |   | **2000** |   |
| **Cash Flows from Operating Activities**                                                                                                   |   |                        | ** ** |   | ** ** |   | ** ** |
| Net income (loss)                                                                                                                          |   | $                           | 4,346      |   | $ | 2,379 |   | $ | (739 | ) |
| Adjustments to reconcile net income to cash provided by  operating activities:                                                             |   |                        |       |   |   |   |   |
| Depreciation and amortization                                                                                                              |   | 8,051                       |       | 7,210 |   | 6,033 |   |
| Increase (decrease) in deferred income taxes                                                                                               |   | 2,790                       |       | 1,525 |   | (742 | ) |
| Restricted stock, stock option, and stock bonus award  compensation                                                                        |   | 459                         |       | 615 |   | 604 |   |
| Gain on sale of lease contracts and notes receivable,  net                                                                                 |   | (15,804                     | )          | (14,928 | ) | (12,078 | ) |
| Interest rate swap breakage cost                                                                                                           |   | 626                         |       | 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                                                                              |   | 11,448                      |       | 9,409 |   | 9,218 |   |
| Increase (decrease) in accrued interest                                                                                                    |   | 22                          |       | (551 | ) | 270 |   |
| Increase (decrease) in accounts payable and accrued  liabilities                                                                           |   | 4,258                       |       | 760 |   | 322 |   |
| Increase (decrease) in accrued income taxes                                                                                                |   | (71                         | )          | 13 |   | (120 | ) |
| Decrease in refundable income taxes                                                                                                        |   | —                      |       | — |   | 260 |   |
| (Increase) decrease in other assets                                                                                                        |   | (2,427                      | )          | (1,103 | ) | (2,038 | ) |
| Cash provided by operating activities                                                                                                      |   | 13,698                      |       | 5,965 |   | 8,096 |   |
|                                                                                                                                       |   |                        |       |   |   |   |   |
| **Cash Flows from Investing Activities**                                                                                                   |   |                        | ** ** |   | ** ** |   | ** ** |
| Origination of lease contracts and notes receivable due  in installments                                                                   |   | (319,708                    | )          | (258,782 | ) | (251,206 | ) |
| Portfolio receipts, net of amounts included in income                                                                                      |   | 74,537                      |       | 79,115 |   | 89,402 |   |
| Proceeds from sales of lease contracts and notes  receivable due in installments                                                           |   | 51,538                      |       | 26,145 |   | 50,818 |   |
| Net proceeds received from term securitization from  reacquisition and resale of lease contracts and notes receivable due in  installments |   | —                      |       | — |   | 9,804 |   |
| Net decrease in notes receivable                                                                                                           |   | 12,338                      |       | 2,950 |   | 1,077 |   |
| Net decrease in security deposits                                                                                                          |   | (897                        | )          | (842 | ) | (828 | ) |
| Net increase (decrease) in other assets                                                                                                    |   | 411                         |       | 266 |   | 346 |   |
| Net (increase) decrease in loans to employees                                                                                              |   | 62                          |       | (339 | ) | (14 | ) |
|                                                                                                                                       |   |                        |       |   |   |   |   |
| Cash used in investing activities                                                                                                          |   | (181,719                    | )          | (151,487 | ) | (100,601 | ) |
|                                                                                                                                       |   |                        |       |   |   |   |   |
| **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                                                                                                    |   | (47,066                     | )          | (49,279 | ) | — |   |
| Proceeds from issuance of other senior notes                                                                                               |   | 269,212                     |       | 153,608 |   | 173,519 |   |
| Repayments of other senior notes                                                                                                           |   | (42,399                     | )          | (51,209 | ) | (307,589 | ) |
| Repayment of subordinated notes                                                                                                            |   | (2,025                      | )          | — |   | — |   |
| Net proceeds (repayments) from revolving notes payable  to banks                                                                           |   | (8,563                      | )          | 3,000 |   | (21,000 | ) |
| Interest rate swap breakage costs                                                                                                          |   | (626                        | )          | (636 | ) | (3,988 | ) |
| Purchase of treasury stock                                                                                                                 |   | (538                        | )          | (495 | ) | (219 | ) |
| (Increase) decrease in restricted cash                                                                                                     |   | (847                        | )          | 86,299 |   | (100,995 | ) |
| Exercise of employee stock options                                                                                                         |   | 121                         |       | 235 |   | 27 |   |
| Repayment of employee stock ownership plan promissory  note                                                                                |   | 105                         |       | 105 |   | 105 |   |
| Cash provided by financing activities                                                                                                      |   | 167,374                     |       | 146,220 |   | 92,505 |   |
| Net increase (decrease) in cash and cash equivalents                                                                                       |   | (647                        | )          | 698 |   | — |   |
| Cash and cash equivalents at beginning of year                                                                                             |   | 698                         |       | — |   | — |   |
| Cash and cash equivalents at end of year                                                                                                   |   | $                           | 51         |   | $ | 698 |   | $ | — |   |
|                                                                                                                                       |   |                        |       |   |   |   |   |
| Supplemental disclosures of cash flow information:                                                                                         |   |                        |       |   |   |   |   |
| Interest paid                                                                                                                              |   | $                           | 21,398     |   | $ | 25,268 |   | $ | 25,371 |   |
| Income taxes paid                                                                                                                          |   | 34                          |       | 140 |   | 228 |   |
| Non-cash transaction:                                                                                                                      |   |                        |       |   |   |   |   |
| Asset sale transfers in satisfaction of senior notes                                                                                       |   | $                           | 120,117    |   | $ | 129,491 |   | $ | 93,297 |   |

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

4

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**HPSC, INC. and Subsidiaries**

 

**NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS**

 

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

 

*Nature ofBusiness_*HPSC, Inc.(“HPSC”) and its consolidated subsidiaries (the “Company”) provide financing,in the form of leases and notes, for equipment and other practice relatedexpenses to the medical and healthcare professions. The Company does not carryany inventory. The Company acquires the financed equipment from vendors attheir customary selling price to other customers. All leases are classified asdirect financing leases. The Company also finances the acquisition ofhealthcare practices by healthcare professionals and provides financing forleasehold improvements, office furniture and equipment, and certain other costsinvolved in opening or maintaining a healthcare provider’s office. The Companyperiodically sells leases and notes in its securitization facilities and tovarious banks.

 

Through its wholly-owned subsidiary, American Commercial FinanceCorporation (“ACFC”), the Company also provides asset-based financing tomanufacturing and distribution companies with borrowing requirements ofgenerally $4,000,000 or less. New originations at ACFC were discontinued in2002, and HPSC is currently winding down its asset-based operations.

 

*Basis ofConsolidation_*Theaccompanying consolidated financial statements include HPSC and the followingwholly-owned subsidiaries: ACFC, an asset-based lender engaged in providingaccounts receivable and inventory financing at variable rates, HPSC BravoFunding, LLC (“Bravo”), HPSC Capital Funding Inc. (“Capital”) (terminated inJune 2001), and HPSC Equipment Receivables 2000-1 LLC II, each aspecial-purpose corporation formed in connection with securitizationfacilities. HPSC Equipment Receivables 2000-1 LLC I is a qualifiednon-consolidated special-purpose entity within the meaning of Statement ofFinancial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities, a replacementof SFAS No. 125”. All inter-company transactions have been eliminated inconsolidation.

 

*Use ofEstimates_*The preparationof financial statements in accordance with accounting principles generallyaccepted in the United States of America requires the Company to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of theseconsolidated financial statements and the reported amounts of revenues andexpenses during the reporting periods. A significant area requiring the use ofmanagement estimates is the allowance for losses on leases and notes. Actualresults could differ from those estimates.

 

*RevenueRecognition_*The Companyfinances equipment only after a customer’s credit has been approved and a leaseor financing agreement for the transaction has been executed. The Companyperforms ongoing credit evaluations of its customers and maintains allowancesfor potential credit losses. When a transaction is initially activated, theCompany records the minimum payments and the estimated residual value of theequipment, if any, associated with the transaction. An amount equal to the sumof the payments due plus the residual value less the cost of the transaction isrecorded as unearned income. The unearned income is recognized as revenue overthe life of the transaction using the effective interest method.  Recognition of revenue on these assets issuspended when a transaction enters the legal collection phase. Also includedin earned income are fees from various portfolio service charges, gains andlosses on prepayments, and miscellaneous income items, net of initial directcost amortization. Notes receivable are reported at their outstanding principalbalances. Interest income on notes receivable is recognized as it is accrued.

 

*Sales of Leasesand Notes Receivable_*TheCompany periodically sells leases and notes in its securitization facilities.Gains on sales of leases and notes are recognized at the time of the sale. Thegain is computed as the excess of the present value of the anticipated futurecash flows plus the fair value of its retained subordinated interest, minusinitial direct costs and expenses and the Company’s current carrying value ofthe assets sold. The Company retains servicing responsibility for financingcontracts sold. Servicing fees on sold assets, which the Company believesclosely approximate its servicing costs, are deferred and recognized as revenuein proportion to the estimated periodic servicing costs.

 

*Debt Issue Costs*_Debt issue costs incurred in securing credit facility financing are capitalizedand subsequently amortized over the term of the credit facility.

 

*Cash and CashEquivalents_*The Companyconsiders all highly liquid investments with maturities of three months or lesswhen acquired to be cash equivalents.

 

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*Restricted Cash_*As part of its servicing obligation under its securitization and bankagreements (Note C), the Company collects certain cash receipts on financingcontracts pledged or sold.  Thesecollections are segregated in separate accounts for the benefit of the entityto which the related leases and notes were pledged or sold and are remitted tosuch entities on a monthly basis.

 

*EstimatedResidual 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 management,based upon its experience and judgment, and generally equal 10% of the originalcost of the equipment.

 

*DeferredOrigination Costs_*TheCompany capitalizes initial direct costs that relate to the origination ofleases and notes in accordance with SFAS No. 91, “Accounting for NonrefundableFees and Costs Associated with Originating or Acquiring Loans and InitialDirect Costs of Leases”. These initial direct costs comprise certain specificactivities related to processing requests for financing, such as the costs tounderwrite the transaction, to prepare and execute the documentation, filingfees, and commission payments. Deferred origination costs are amortized usingthe effective interest method over the life of the receivable as an adjustmentof yield.

 

*Allowance forLosses_*The Companyrecords an allowance for estimated losses in its portfolio. The allowance isbased on an****evaluation of its portfolio quality, delinquencytrends, general economic conditions, historical loss experiences, as well as a specific analysis of potential lossaccounts.  An account is eitherspecifically reserved or written off when deemed uncollectible.

 

*Inventory*_ The Company occasionally repossesses equipment from lessees or borrowerswho have defaulted on their obligations to the Company. There was no suchequipment held for resale at December 31, 2002 or 2001.

 

*Property andEquipment_*Property andequipment used by the business are recorded at cost and depreciated using the straight-linemethod over a period of three to five years. Leasehold improvements areamortized over the shorter of the estimated life of the asset or the leaseterm. Upon retirement or other disposition, the cost and related accumulateddepreciation of the asset are removed from the accounts and the resulting gainor loss is reflected in income. Net property and equipment, which are includedas a component of other assets, totaled $1,192,000 and $1,492,000 at December31, 2002 and 2001, respectively.

 

*Interest RateSwap Contracts_*Under the terms of its securitizationagreements (Note C), the Company is required to enter into interest rate swapcontracts to manage its exposure to fluctuations in interest rates. Interestrate swap contracts are used to convert substantial portions of the Company’sdebt from a variable-rate to a fixed-rate of interest. The periodic netinterest payments from the swap contracts are recognized in the Company’sconsolidated statements of operations as a component of interest expense. TheCompany does not hold or issue derivative financial instruments for tradingpurposes and is not a party to leveraged instruments. The Company hasestablished a control environment that includes procedures for risk assessmentand approval, reporting and monitoring of derivative financial instruments.

 

On January 1,2001, the Company adopted SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities” as amended by SFAS No. 138.  SFAS No. 133, as amended, requires all derivative instruments tobe recorded on the Consolidated Balance Sheet as either assets or liabilitiesand measured at fair value. Prior to January 1, 2001, the Company accounted forinterest rate swap contracts using settlement accounting.

 

The Company hasdesignated its interest rate swap contracts to hedge its exposure to thevariability in expected future cash flows attributable to its variable ratedebt. Accordingly, the Company assesses the effectiveness of the hedge for eachreporting period. The fair value of each interest rate swap contract isrecorded at fair value on the Consolidated Balance Sheet. Unrealized gains orlosses, representing the effective portion of the hedge, are excluded fromearnings and reflected in stockholders’ equity as a separate component ofaccumulated other comprehensive income (loss), net of taxes. The ineffectiveportion of the hedge is determined by comparing the changes in the fair valueof the swap contract to changes in the fair value of a hypothetical swap havingterms equal to the hedged debt. Any ineffective portion of the hedge isrecognized in earnings. During the years ended December 31, 2002 and 2001, theswap contracts were effective in offsetting changes in the cash flows of theCompany’s variable rate debt obligations. Amounts recorded in accumulated othercomprehensive income (loss) will be reclassed out either as the hedged debtamortizes or as interest rates fluctuate.

 

*Accounting forStock-Based Compensation_*The Company accounts for stock-based compensation in accordance withAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees” (Note I).  TheCompany applies the intrinsic value method under APB No. 25 to measurecompensation expense related to grants of stock options, and has disclosed thepro forma information required by SFAS No. 123, “Accounting for Stock-BasedCompensation”.  No stock-basedcompensation costs related to stock options are reflected in net income.  If the Company had used the fair-valuemethod to measure compensation under the

 

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accounting provisions of SFAS No. 123, reported net income (loss) andbasic and diluted net income (loss) per share would have been as follows:

 
| **(in thousands, except per share amounts)**                                                                               |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                                                       |   |     |   |     |   |     |   |
| Net income (loss), as reported                                                                                             |   | $        | 4,346  |     | $      | 2,379    |   | $ | (739 | ) |
| Less: Total stock-based compensation expense determined  under fairValue method for all  stock options granted, net of tax |   | (1,000   | )      | (961     | )      | (777     | )      |
| Pro forma net income (loss)                                                                                                |   | $        | 3,346  |     | $      | 1,418    |   | $ | (1,516 | ) |
|                                                                                                                       |   |     |   |     |   |     |   |
| Basic net income (loss) per share, as reported                                                                             |   | $        | 1.07   |     | $      | 0.60     |   | $ | (0.19 | ) |
| Basic net income (loss) per share, pro forma                                                                               |   | $        | 0.82   |     | $      | 0.36     |   | $ | (0.39 | ) |
|                                                                                                                       |   |     |   |     |   |     |   |
| Diluted net income (loss) per share, as reported                                                                           |   | $        | 1.00   |     | $      | 0.55     |   | $ | (0.19 | ) |
| Diluted net income (loss) per share, pro forma                                                                             |   | $        | 0.77   |     | $      | 0.33     |   | $ | (0.39 | ) |

 

For purposes of determining the above disclosure, the fair value ofoptions on their grant date was measured using the Black-Scholes option pricingmodel. Key assumptions used to apply this pricing model were as follows:

 
|                                     |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                     |   |     |   |     |   |     |   |
| Weighted-average risk-free interest rate |   | 4.7      | %      | 4.2      | %      | 6.0      | %      |
| Expected life of option grants           |   | 10 years |   | 10 years |   | 10 years |   |
| Expected volatility of stock             |   | 21.9     | %      | 24.1     | %      | 65.3     | %      |

 

The pro forma presentation only includes the effects of grants madesubsequent to January 1, 1995.  The proforma amounts may not be indicative of the future benefit, if any, to bereceived by the option holder.

 

*DeferredCompensation_*Deferredcompensation, which includes notes receivable from the Company’s Employee StockOwnership Plan (“ESOP”) and deferred compensation related to restricted stockawards, was as follows at December 31:

 
| **(in thousands)** |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------|--------|----------|--------|----------|--------|----------|--------|
|               |   |     |   |     |   |     |   |
| ESOP               |   | $        | 106    |     | $      | 211      |   | $ | 316 |   |
| Restricted stock   |   | —   |   | 94       |   | 319      |   |
| Total              |   | $        | 106    |     | $      | 305      |   | $ | 635 |   |

 

*Income Taxes_* Currenttax liabilities or assets are recognized, through charges or credits to thecurrent tax provision, for the estimated taxes payable or refundable for thecurrent year. Net deferred taxes are recognized, through charges or credits tothe deferred tax provision, for the estimated future tax effects, based onenacted tax rates, attributable to temporary differences. Deferred taxliabilities are recognized for temporary differences that will result inamounts taxable in the future, and deferred tax assets are recognized fortemporary differences and tax benefit carryforwards that will result in amountsdeductible or creditable in the future. The effect of enacted changes in taxlaw, including changes in tax rates, on these deferred tax assets andliabilities is recognized in income in the period that includes the enactmentdate. A deferred tax valuation reserve is established if it is more likely thannot that all or a portion of the Company’s deferred tax assets will not berealized. Changes in the deferred tax valuation reserve are recognized throughcharges or credits to the deferred tax provision.

 

*RecentlyIssued Accounting Pronouncements_* The Company adopted theprovisions of Statement of Position (“SOP”) 01-6, “Accounting by CertainEntities (Including Entities With Trade Receivables) That Lend to or Financethe Activities of Others” on January 1, 2002. The Company determined that the adoption of this SOP did not have amaterial impact on its consolidated financial statements.

 

In April 2002, SFAS No. 145, “Rescission of FinancialAccounting Standards Board (“FASB”) Statements No. 4, 44, and 64, Amendment ofFASB Statement No. 13, and Technical Corrections” was issued.  This statement rescinds and modifies earlierpronouncements, makes various technical corrections, clarifies meanings, andfurther describes their applicability under changed

 

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conditions.  The provisions ofthis statement will be effective for all fiscal years beginning after May 15,2002.  The accounting requirementsprovided by SFAS No. 145 will not have a material effect on the Company’sconsolidated financial statements.

 

The FASB issued SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities” in July 2002.  The standard requires companies to recognizecosts associated with exit or disposal activities when they are incurred ratherthan at the date of a commitment to an exit or disposal plan.  Previous accounting guidance was provided byEITF Issue No. 94-3, “Liability Recognition for Certain Employee TerminationBenefits and Other Costs to Exit an Activity (including Certain Costs Incurredin a Restructuring).”  SFAS No. 146replaces EITF Issue No. 94-3.  Theprovisions of SFAS No. 146 are to be applied prospectively to exit or disposalactivities initiated after December 31, 2002. The new accounting requirements of SFAS No. 146 will not have a materialimpact on the Company’s consolidated financial results.

 

In October 2002, SFAS No. 147 “Acquisitions of CertainFinancial Institutions” was issued. This statement addresses the financial accounting and reporting for theacquisition of all or part of a financial institution, except for transactionsbetween mutual enterprises.  The newaccounting requirements of this statement were effective beginning October 1,2002.  The adoption of this statementdid not have a material effect on the Company’s consolidated financialstatements.

 

The FASB issuedInterpretation No. 45 “Guarantor’s accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” inNovember 2002.  This interpretation elaborateson the disclosures to be made by a guarantor in its interim and annualfinancial statements about its obligations under certain guarantees that it hasissued.  It also clarifies that aguarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee.  The Company’s asset-basedlending subsidiary, ACFC, will issue, from time to time, trade guarantees forits customers’ purchases of supplies from vendors. As of December 31, 2002,ACFC had no such guarantees outstanding.

 

SFAS No. 148 “Accounting for Stock-BasedCompensation—Transition and Disclosure, an amendment to SFAS No. 123” wasissued in December 2002.  The statementprovides alternative methods of transition for a voluntary change to the fairvalue based method of accounting for stock-based employee compensation.  In addition, this statement amends thedisclosure requirements of Statement No. 123 to require prominent disclosuresin both annual and interim financial statements about the method of accountingfor stock-based employee compensation and the effect of the method used onreporting.  The Company has adopted thedisclosure provisions of this standard as of December 31, 2002.

 

In January 2003, FASB issued Interpretation No. 46“Consolidation of Variable Interest Entities”. This interpretation of Accounting Research Bulletin No. 51 “ConsolidatedFinancial Statements”, addresses consolidation by business enterprises ofvariable interest entities (“VIE”), also commonly referred to as specialpurpose entities (“SPE”).  Theinterpretation requires consolidation of a VIE with an entity based on certaineconomic factors such as the extent of obligations of an entity to absorb theexpected losses or the rights of an entity to receive expected residual returnsfrom a VIE.  Previous accountinginterpretations required consolidation of a VIE based on control of the VIEthrough voting interests.  In the normalcourse of financing its business activities, the Company utilizes both onbalance sheet consolidated SPEs as well as off balance sheet SPE’s whichqualify for non-consolidation pursuant to SFAS No. 140.  The Company does not believe the provisionsof Interpretation No. 46 will have an impact on the Company as a result of aspecific exemption within the Interpretation for transferors of financialassets to a qualified SPE, as such term is defined in SFAS No. 140.

 

*Reclassifications_*Certain amounts in the 2001 and 2000 consolidatedfinancial statements have been reclassified to conform to the current yearpresentation.

 

**NOTE B. LEASESAND NOTES RECEIVABLE**

 

The Company’s financing contract portfolio consists of twogeneral categories of assets.

 

The first category consists ofleases and notes due in installments to HPSC, which comprise approximately 96% and 91% of the Company’sconsolidated net investment in leases and notes at December 31, 2002 and2001, respectively. The majority of these leases and notes are from licensedmedical professionals, principally dentists, who practice in individual orsmall group practices. Approximately 70%of these leases and notes pertain toequipment financing while approximately 30%relate to practice financing, leasehold improvements, office furniture, workingcapital and supplies. The Company operates principally in the portion of thehealthcare finance market where the size of the transaction is $250,000 orless, generally referred to as the “small-ticket” market. The averagesize of an obligor’s original obligation under a financing contract originatedby the Company during 2002 was approximately $40,000. The leases and notes arenon-cancelable contracts providing for a full payout at a fixed rate, withterms ranging from 12 to 84

 

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months. The Company’s leases provide for a purchase option at an amountapproximating the fair value of the equipment at maturity, generally equal to10% of the original equipment cost.

 

### **The second category consists of notes receivable due toACFC and progress payment notes receivable due to HPSC, which together compriseapproximately 4% and 9% of theCompany’s net investment in leases and notes at December 31, 2002 and2001, respectively.  The notes to ACFC($12,826,000 at December 31, 2002) consist of secured, asset-based,revolving lines of credit of $4 million or less to small and medium-sizedmanufacturers and distributors, at variable interest rates. Advances on arevolving loan generally do not exceed 80% of a borrower’s eligible accountsreceivable or 50% of the value of a borrower’s active inventory.  ACFC loans, which typically have terms oftwo to three years, are “fully followed”, which means ACFC receives dailysettlement statements of its borrower’s accounts receivable and receives dailycollections into ACFC controlled collection accounts. On December 31, 2002,ACFC sold five revolving loans to a third party. At the time of the sale, theloans had a net book value of $7,426,000. The Company recorded a pre-tax lossof $743,000, which is included in “Gain on sales of leases and notes, net” onthe Consolidated Statement of Operations. The progress payment notes receivabledue to HPSC ($6,525,000 at December 31, 2002) relate to progress payments madefor construction or leasehold improvements in advance of the borrower’sexecuting a lease or finance agreement with the Company. These demand notes aresecured by a blanket lien on all the assets of the licensed healthcareprofessional’s practice.**

 

The Company’s receivables are subject to creditrisk. To reduce this risk, the Company has adopted underwriting policies forapproving leases and notes.  Additionally, the Company may be subject to limited recourse from leasesand notes sold under certain securitization agreements (Notes C and D).  Such risk of loss to the Company isgenerally limited to the extent of the Company’s retained interest and residualvalues in the financing contracts sold.

 

A summary of activity in the Company’sconsolidated allowance for losses for each of the years in the three-yearperiod ended December 31, 2002 is as follows:

 
| **(in thousands)**         |   | **2002** |    | **2001** |   | **2000** |   |
|----------------------------|--------|----------|---------|----------|--------|----------|--------|
|                       |   |     |    |     |   |     |   |
| Balance, beginning of year |   | $        | (15,359 | )        | $      | (14,170  | )      | $ | (9,150 | ) |
| Provision for losses       |   | (11,448  | )       | (9,409   | )      | (9,218   | )      |
| Charge-offs                |   | 10,255   |    | 8,253    |   | 4,287    |   |
| Recoveries                 |   | (348     | )       | (33      | )      | (89      | )      |
|                       |   |     |    |     |   |     |   |
| Balance, end of year       |   | $        | (16,900 | )        | $      | (15,359  | )      | $ | (14,170 | ) |

 

The total gross contractual balances of delinquentleases and notes, both owned and managed by the Company, which were over 90days past due, amounted to $27,973,000 at December 31, 2002 compared to$24,945,000 at December 31, 2001. An account is considered delinquent whennot paid within 30 days of the billing due date.

 

The Company’s agreements with its customers,except for its notes receivable, are non-cancelable and provide for a fullpayout at a fixed financing rate over terms of one to seven years. Scheduledfuture receipts on leases and notes, plus anticipated cash flows on theretained interest in leases and notes sold, were as follows at December 31,2002:

 

*(inthousands)*

 
|                |   | **Leases and  Notes Due in  Installments** |    | **Retained  Interest in  Leases and  Notes Sold** |   |
|---------------------|--------|--------------------------------------------|---------|---------------------------------------------------|--------|
| 2003                |   | $                                          | 135,451 |                                              | $      | 14,560 |   |
| 2004                |   | 109,575                                    |    | 11,654                                            |   |
| 2005                |   | 91,571                                     |    | 8,763                                             |   |
| 2006                |   | 69,713                                     |    | 5,963                                             |   |
| 2007                |   | 48,536                                     |    | 3,516                                             |   |
| 2008 and thereafter |   | 39,313                                     |    | 1,843                                             |   |
| Total               |   | $                                          | 494,159 |                                              | $      | 46,299 |   |

 

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**NOTE C. DEBT ANDSECURITIZATION FACILITIES**

 

*Revolving Credit Borrowings*- The Company utilizes its revolving creditborrowings primarily to temporarily warehouse new financing contracts untilpermanent fixed-rate financing is available as well as to finance a portion ofthe loan portfolio of its ACFC subsidiary. In May 2001 the Company renewed and amended its revolving creditfacility with Fleet National Bank (the “Fleet Revolver”), providing the Companywith available borrowings up to $83,500,000 through May 2002.  In May 2002, the Fleet Revolver was againrenewed, providing availability up to $75,000,000 through August 2002.  Under the terms of the Fleet Revolver,interest on the Company’s base borrowings was computed at variable interestrates of prime plus .75% to 1.25% and interest on excess borrowings wascomputed at LIBOR plus 2.25% to 2.75%. The level of spread to be paid above thebase rate and LIBOR rates was dependent upon the Company’s balance sheetleverage as well as compliance with certain performance covenants.  At December 31, 2001, the Company had$52,000,000 outstanding under the Fleet Revolver, at a weighted-averageinterest rate of 4.6%.

 

In August2002, Fleet National Bank assigned the Fleet Revolver to Foothill CapitalCorporation, as Agent. The Company contemporaneously executed an agreement withFoothill Capital Corporation and a group of lenders (the “Foothill Revolver”).  The Foothill Revolver provides for a line ofcredit to HPSC (the “HPSC Foothill Revolver”) and a separate line of credit toACFC (the “ACFC Foothill Revolver”). Substantially all of the assets of theCompany, which does not include assets pledged or sold under securitizations,have been pledged to HPSC’s lenders as security under its credit arrangement.Under the terms of the HPSC Foothill Revolver, the Company may borrow up to$50,000,000 at variable interest rates of prime plus .50% to 1.00% and at LIBORplus 2.50% to 3.00%, depending upon the Company’s balance sheet leverage.  This line was temporarily increased inNovember 2002 to $60,000,000, through January 24, 2003 (see subsequent eventsNote O). The HPSC Foothill Revolver expires in August 2005. Under the ACFCFoothill Revolver, ACFC may borrow up to $20,000,000 at a variable interestrate of prime plus 1.00% for the first 180 days and prime plus 2.00%thereafter.  The ACFC Foothill Revolverexpires on February 5, 2003 (see subsequent events Note O).  Both the HPSC and the ACFC Revolvers aresubject to certain financial covenant requirements including, among others,tangible net worth, leverage, profitability levels, and interest coverage.  Initial proceeds from the Foothill Revolverwere used to repay remaining amounts due to Fleet National Bank under the FleetRevolver.  At December 31, 2002, theCompany had $42,606,000 outstanding under the HPSC Foothill Revolver and$831,000 outstanding under the ACFC Foothill Revolver.  The weighted-average interest rate of theFoothill Revolver was 5.25% at December 31, 2002.

 

*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 through the operation of a sinking fundat established redemption prices, plus accrued interest to the date ofredemption. Beginning July 1, 2002, the Company began redeeming, throughscheduled, quarterly sinking fund payments, a portion of the aggregateprincipal amount of the Notes at a redemption price of $1,000,000 plus accruedinterest to the redemption date. Such payments are required on January 1, April1, July 1, and October 1 of each year until maturity.  At December 31, 2002 and 2001, the Company had outstanding seniorsubordinated notes of $17,960,000 and $19,985,000, respectively. The seniorsubordinated notes are full recourse to the Company.

 

*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 secured by certain of the Company’s financingcontracts and are full recourse to the Company. At December 31, 2002 and 2001,the Company had on its consolidated balance sheet outstanding borrowings of$7,211,000 and $11,559,000, respectively, under such loan agreements, at annualinterest rates ranging from 6.5% to 8.0%.

 

*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 2000-1facility (“ER 2000-1 Facility”). In connection with its securitizationfinancing activities, the Company has formed the following bankruptcy-remote,special-purpose entities: HPSC Bravo Funding LLC (“Bravo”), HPSC EquipmentReceivables 2000-1 LLC I (“ER 2000-1 LLC I”), and HPSC Equipment Receivables2000-1 LLC II (“ER 2000-1 LLC II”). Securitization is a process in which poolsof financing contracts are sold to a special-purpose entity which issues notesto investors to pay for the contracts. The notes are secured by a pledge of theassets in the financing contract pools. Principal and interest on the notes arepaid from the cash flows generated from the financing contracts. In bothsecuritizations, the Company has retained the responsibility for servicing thefinancing contract portfolio. Under certain circumstances, the Company, as theservicer, may also be obligated to advance amounts due on a financing contractif an obligor fails to remit a payment when due. The Company is reimbursed forsuch advances from available funds upon subsequent collection from the obligor.

 

For accounting purposes, the Company treats thesesecuritizations as either financings (on-balance sheet transactions) or sales(off-balance sheet transactions) pursuant to the accounting provisions of SFASNo. 140. In an on-balance sheet securitization, the securitized financingcontracts are recorded as assets with the proceeds recorded as senior notes onthe Company’s consolidated balance sheet. In an off-balance sheetsecuritization,  the securitized financingcontracts are treated as sold and removed from the consolidated balance sheetand a gain or loss is recognized at the time of the sale. For these off-balancesheet transactions, the previous

 

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carrying amount of the transferred financing contracts is allocatedbetween the financing contracts sold and a retained interest based on therelative fair values of the financing contracts on the date of transfer. TheCompany estimates fair value based on the present value of expected future cashflows, using management’s best estimates of anticipated credit losses anddiscount rates. Management believes that such key estimates are consistent withthose that would be used by other market participants in determining fair valuefor the same retained interest. In both on-and-off-balance sheetsecuritizations, the Company continues 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 $450,000,000. Under the terms of theBravo Facility, the Company contributes certain financing contracts to Bravowhich, in turn, either pledges or sells those contracts to a commercial paperconduit entity. Credit enhancement is provided to the note holders throughguarantees provided by MBIA, Inc. as to the payment of principal and intereston the notes. In the case of financing contracts pledged by Bravo, the financingcontracts and the associated debt of Bravo to the conduit entity are includedon the Company’s consolidated balance sheet. At December 31, 2002 and 2001,this outstanding debt totaled $220,934,000 and $126,468,000, respectively, withweighted-average swapped interest rates of 3.79% and 5.45%, respectively. In the case of financing contractssold by Bravo, the financing contracts and associated debt are removed from theCompany’s consolidated balance sheet. Riskof loss to the Company is limited to the extent of the Company’s retainedinterest and residual values in the financing contracts sold. AtDecember 31, 2002 and 2001, the total outstanding balance of these sold,off-balance sheet financing contracts was $213,624,000 and $74,388,000,respectively.  The Bravo Facilityexpires in June 2003.  The Companyexpects that it will be able to renew the Bravo Facility. However, in the eventthe facility is not renewed, the Facility may then be limited to the thenexisting outstandings and may not be available to the Company to provideadditional liquidity.

 

In August 2002, the covenant requirements in theBravo Facility were amended to substantially match the covenant requirements ofthe HPSC Foothill Revolver.

 

The Company entered into a financing arrangement,as part of the Bravo Facility, with ING Capital LLC (“ING”) in August 2002,pursuant to which ING agreed to provide the Company with additional liquidityof up to 3.75% of financing contracts held in the MBIA portion of the BravoFacility, up to a maximum amount of $20,000,000 (the “ING portion of the BravoFacility”).   Interest onborrowings under the ING portion of the Bravo Facility is based on one-monthLIBOR plus 3%.  Amounts due ING aresubordinate to amounts due on the Bravo notes. The ING portion of the Bravo Facility contains delinquency and defaultcovenants that are more restrictive than those contained in the MBIA portion ofthe Bravo Facility.  Proceeds fromfinancings with ING were used to retire amounts outstanding under the Company’sFleet and Foothill Revolver agreements. At December 31, 2002, the ING portion of the Bravo Facility consisted ofoutstanding on-balance sheet debt of $16,577,000.

 

*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, collateral consisting of leases and notes transferred fromHPSC, 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.

 

In the case of financing contracts sold to ER2000-1 LLC I, the financing contracts and associated debt are removed from theCompany’s Consolidated Balance Sheet. Riskof loss to the Company is limited to the extent of the Company’s retainedinterest and residual values in the financing contracts sold. AtDecember 31, 2002 and 2001, the total outstanding balance of these sold,off-balance sheet financing contracts was $128,964,000 and $212,602,000,respectively. Financing contracts transferred to ER 2000-1 LLC II were pledgedas collateral for the notes, with the financing contracts and associated debtincluded in the Company’s Consolidated Balance Sheet. At December 31, 2002 and2001, this outstanding debt totaled $100,145,000 and $146,779,000,respectively, with a weighted-average interest rate of 6.67% for both years.

 

HPSC provided additional credit enhancement to theER 2000-1 note holders through the creation of a cash reserve account and aresidual payment account. Pursuant to the terms of the ER 2000-1 securitizationagreements, certain excess cash flows generated by the financing contractportfolio are deposited to the cash reserve account or residual paymentaccount, up to agreed upon limits. These interest-bearing restricted cashaccounts are available to fund monthly interest and principal payments on theER 2000-1 notes in the event of shortfalls in monthly collections on thefinancing contracts.  At December 31,2002 and 2001, the balance in the restricted cash reserve account was$7,054,000 and $10,191,000, respectively, and the balance in the restrictedcash residual payment account

 

11

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was $295,000 and $1,433,000, respectively. The Company may also provideadditional credit enhancement through the substitution of new leases and notesfor leases and notes previously contributed into ER 2000-1 LLC II, up tocertain defined limits.

 

ER 2000-1 LLC I and ER 2000-1 LLC II originallyissued seven classes of equipment contract backed notes and one class ofequipment contract backed variable funding notes (“VFN”). To provide creditenhancement, the classes of notes are structured to be payable insenior/subordinated order of priority. Details of the notes, ranked in senior/subordinated priority, are asfollows at December 31, 2002:

 

*($ inthousands)*

 
| **Class**          |   | **Original  Principal  Balance (Note 1)** |    | **Remaining  Principal  Balance (Note 1)** |   | **Coupon  Rate,  per annum** |   | **Interest  Accrual  Method** |   | **Rating  (Unaudited)** |   |
|--------------------|--------|-------------------------------------------|---------|--------------------------------------------|--------|------------------------------|--------|-------------------------------|--------|-------------------------|--------|
| Class A            |   | $                                         | 414,466 |                                       | $      | 191,479                      |   | 1 Month USD  LIBOR +0.30      | %      | Actual/360              |   | Aaa/AAA |   |
| Class B-1          |   | 29,959                                    |    | 13,841                                     |   | 1 Month USD  LIBOR + 0.50    | %      | Actual/360                    |   | Aa3/AA                  |   |
| Class B-2          |   | 13,267                                    |    | 6,129                                      |   | 7.23                         | %      | 30/360                        |   | Aa3/AA                  |   |
| Class C            |   | 19,070                                    |    | 8,810                                      |   | 7.70                         | %      | 30/360                        |   | A3/A                    |   |
| Class D            |   | 5,085                                     |    | 2,349                                      |   | 8.11                         | %      | 30/360                        |   | Baa3/BBB                |   |
| Class E            |   | 8,899                                     |    | 4,112                                      |   | 10.00                        | %      | 30/360                        |   | Ba2/BB                  |   |
| Class F            |   | 6,360                                     |    | 2,938                                      |   | 12.91                        | %      | 30/360                        |   | B1                      |   |
| Class VFN (Note 2) |   | 30,000                                    |    | —                                     |   | 1 Month USD  LIBOR + 1.00    | %      | Actual/360                    |   | —                  |   |
| Total              |   | $                                         | 527,106 |                                       | $      | 229,658                      |   |                          |   |                    |   |   |   |

 

----

| Note  1:  Principal balances include  outstanding obligations which reflect both off-balance sheet sales of  financing contracts (ER 2000-1 LLC I) as well as on-balance sheet debt  obligations (ER 2000-1 LLC II).

Note  2:  The Class VFN notes were never  issued, however, and remain available to the Company. |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

A summary of the Company’s total debt obligations and the totalon-and-off-balance sheet financing contracts outstanding in the Company’svarious securitization facilities at December 31, 2002 is as follows:

 
| **(in thousands)**                                   |   | **On-Balance  Sheet Debt  Obligations** |       | **Off-Balance  Sheet  Sold Financing  Contracts** |       | **Total**   |       |
|------------------------------------------------------|--------|-----------------------------------------|------------|---------------------------------------------------|------------|-------------|------------|
| **HPSC Foothill Revolver**                           |   | **$**                                   | **42,606** | ** **                                        | **$**      | **—**  | ** ** | **$** | **42,606** | ** ** |
| **ACFC Foothill Revolver**                           |   | **831**                                 | ** ** | **—**                                        | ** ** | **831**     | ** ** |
| **Unsecured Senior Subordinated Notes**              |   | **17,960**                              | ** ** | **—**                                        | ** ** | **17,960**  | ** ** |
| **Various banks**                                    |   | **7,211**                               | ** ** | **—**                                        | ** ** | **7,211**   | ** ** |
| **Bravo (MBIA)**                                     |   | **220,934**                             | ** ** | **213,624**                                       | ** ** | **434,558** | ** ** |
| **Bravo (ING)**                                      |   | **16,577**                              | ** ** | **—**                                        | ** ** | **16,577**  | ** ** |
| **ER 2000-1 LLC I and LLC II**                       |   | **100,694**                             | ** ** | **128,964**                                       | ** ** | **229,658** | ** ** |
| **Subtotal**                                         |   | **406,813**                             | ** ** | **342,588**                                       | ** ** | **749,401** | ** ** |
| **Less: Original issue discount on ER 2000-1 notes** |   | **(549**                                | **)**      | **—**                                        | ** ** | **(549**    | **)**      |
| Total                                                |   | $                                       | 406,264    |                                              | $          | 342,588     |       | $ | 748,852 |   |

 

Scheduled future annual maturities of the Company’s on-balance sheetdebt obligations, as detailed above, is as follows at December 31, 2002:

 
| **(in thousands)**  |   | **HPSC and  ACFC  Revolver** |   | **Senior  Subordinated** |   | **Various  Banks** |   | **Bravo  (MBIA)** |   | **Bravo  (ING)** |   | **ER 2000-1  (at face value)** |   | **Total** |   |
|---------------------|--------|------------------------------|--------|--------------------------|--------|--------------------|--------|-------------------|--------|------------------|--------|--------------------------------|--------|-----------|--------|
| 2003                |   | $                            | 831    |                     | $      | 4,000              |   | $                 | 2,198  |             | $      | 50,745                         |   | $         | 5,820  |   | $ | 37,315 |   | $ | 100,909 |   |
| 2004                |   | —                       |   | 4,000                    |   | 2,268              |   | 44,118            |   | 2,983            |   | 26,062                         |   | 79,431    |   |
| 2005                |   | 42,606                       |   | 4,000                    |   | 1,806              |   | 40,552            |   | 2,689            |   | 18,730                         |   | 110,383   |   |
| 2006                |   | —                       |   | 4,000                    |   | 928                |   | 33,765            |   | 2,206            |   | 12,809                         |   | 53,708    |   |
| 2007                |   | —                       |   | 1,960                    |   | 11                 |   | 26,651            |   | 1,598            |   | 5,553                          |   | 35,773    |   |
| 2008 and thereafter |   | —                       |   | —                   |   | —             |   | 25,103            |   | 1,281            |   | 225                            |   | 26,609    |   |
| Total               |   | $                            | 43,437 |                     | $      | 17,960             |   | $                 | 7,211  |             | $      | 220,934                        |   | $         | 16,577 |   | $ | 100,694 |   | $ | 406,813 |   |

 

12

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**NOTE D.ADDITIONAL SECURITIZATION DISCLOSURES**

 

As described in Note C, the Company routinely sellsleases and notes pursuant to sales and securitization agreements. Under each ofits securitization agreements, the Company continues to service the financingcontracts sold, subject to complying with certain covenants. The Companybelieves that its servicing fee approximates its estimated servicing costs, butit has limited market basis to assess the fair value of its servicing asset.  Accordingly, the Company has valued itsservicing asset and deferred liability at zero.  The Company recognizes servicing fee revenue as earned over theservicing period in proportion to its servicing costs. For fiscal years endedDecember 31, 2002, 2001, and 2000, the Company recognized servicing feerevenues of $942,000, $1,349,000, and $405,000, 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, 2002:

 

| **(in thousands)**                                      |   | **2002** |   | **2001** |   |
|---------------------------------------------------------|--------|----------|--------|----------|--------|
| Cash proceeds from new securitizations                  |   | $        | 51,538 |     | $      | 26,145 |   |
| Cash collections from obligors, remitted to transferees |   | (124,371 | )      | (91,004  | )      |
| Servicing fees cash received                            |   | 1,511    |   | 1,460    |   |
| Transferor retained interest cash flows                 |   | 7,310    |   | 7,075    |   |
| Net servicing advances                                  |   | (1,273   | )      | (1,863   | )      |
|                                                         |        |          |        |          |        |  |  |

 

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,**          |   |
| **(in thousands)**                                 |   | **2002**                  |    | **2001**                                  |   | **2002**              |   | **2001** |   | **2002** |   | **2001** |   |
| Licensed professional financing                    |   | $                         | 742,839 |                                      | $      | 620,795               |   | $ | 22,732 |   | $ | 20,055 |   | $ | 8,720 |   | $ | 7,655 |   |
| Commercial and industrial financing                |   | 12,826                    |    | 27,611                                    |   | —                |   | — |   | 1,187 |   | 565 |   |
| Total owned and managed                            |   | 755,665                   |    | 648,406                                   |   | $                     | 22,732 |   | $ | 20,055 |   | $ | 9,907 |   | $ | 8,220 |   |
| Less:                                              |   |                      |    |                                      |   |                  |   |   |   |   |   |   |   |
| Securitized licensed professional financing assets |   | 297,631                   |    | 251,410                                   |   |                  |   |   |   |   |   |   |   |
| Total owned                                        |   | $                         | 458,034 |                                      | $      | 396,996               |   |   |   |   |   |   |   |   |   |

 

The Company’s primary exposure in determining thefair value of its retained interest in securitized financing contracts iscredit risk associated with the obligors on these contracts. The Company’sretained interest in its financing contracts is subordinate to the interests ofits credit providers.  In recording thenet gain upon the sale of financing contracts and the fair value of itsretained interest, the Company assumes a loss rate of approximately 0.50% perannum on a static pool basis, and discounts its retained interest at implicitrates ranging from 10.6% to 14.8%.  Prepayment risk on securitized financing contracts is limited dueto the Company’s prepayment policies with its obligors. To eliminate interestrate risk, the Company enters into interest rate swap contracts as a hedgeagainst its variable rate obligations. The fair value of the retained interest in the financing contracts soldis reviewed for impairment on a quarterly basis.  Risk of loss to theCompany under its Bravo and ER 2000-1 sales agreements is limited to the extentof the Company’s retained interest and residual values in the financingcontracts sold to those facilities.

 

The following is a summary at December 31, 2002 ofkey assumptions and the sensitivity of the fair value of retained interest cashflows to immediate 10 percent and 20 percent adverse changes in thoseassumptions:

 
| **($ in thousands)**                       |   | **Current** |   | **10%**    |   | **20%**    |   |
|--------------------------------------------|--------|-------------|--------|------------|--------|------------|--------|
| Retained interest                          |   | $           | 46,299 | ** ** |   | ** ** |   | ** ** |
| **Expected credit losses (annual rate)**   |   | **0.5**     | **%**  | **$ (91**  | **)**  | **$ (183** | **)**  |
| Residual cash flows discount rate (annual) |   | 11.9        | %      | $ (605     | )      | $ (1,189   | )      |
|                                            |        |             |        |            |        |            |        |  |

 

These sensitivities are presented as hypotheticalassumptions and do not reflect actual experience.  Changes in the fair value based on a 10 percent variation inassumptions generally cannot be extrapolated because the relationship of thechange in assumption to the change in the fair value may not be linear.  Also, the effect of a variation in a particularassumption on the fair value of the retained interest is calculated withoutchanging any other assumption; in reality, the change in one assumption mayresult in changes in another, which may magnify or counteract thesensitivities.

 

13

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### **NOTE E. DERIVATIVE INSTRUMENTS**

 

At December 31, 2002, the Company had fourteeninterest rate swap contracts outstanding hedging variable-rate exposures toon-balance sheet debt obligations and seventeen interest rate swap contracts assigned to non-consolidatedentities for the purpose of hedging variable-rate exposures for sold financingcontracts. The net fair value of the swap contracts hedging on-balance sheetdebt obligations, which is recorded on the Company’s balance sheet at December31, 2002, was a liability of $9,406,000. Inaddition, the Company has assigned portions of interest rate swap contracts tothird parties in connection with sales of leases and notes receivable. Thenet fair value of the swap contracts hedging off-balance sheet amounts, whichis not recorded on the Company’s balance sheet, was a net liability of $16,954,000 at December 31, 2002.

 

Anofficer of the Company is a member of an advisory committee of an affiliate ofa counterparty to certain interest rate swap contracts.

 

The Company’s activity in accumulated othercomprehensive loss related to derivatives classified as cash flow hedges forthe years ended December 31, 2002 and 2001 is as follows:

 

| **(in thousands, net of deferred taxes)**                                                                      |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                                                                           |   |     |   |     |   |
| Beginning balance, January 1                                                                                   |   | $        | (4,384 | )        | $      | — |   |
| Cumulative effect adjustment upon the adoption of SFAS  No. 133                                                |   | —   |   | (1,062   | )      |
| Change in fair value of derivatives during the period                                                          |   | (5,137   | )      | (5,650   | )      |
| Interest rate swap contracts assigned to qualified  special purpose entities upon securitization, net of taxes |   | 3,430    |   | 1,942    |   |
| Realized swap breakage costs included in net income,  net of taxes                                             |   | 380      |   | 386      |   |
| Accumulated derivative loss included in accumulated  other comprehensive loss, at December 31                  |   | $        | (5,711 | )        | $      | (4,384 | ) |

 

During the years ended December 31, 2002 and 2001, theCompany’s interest rate swaps were effective at offsetting changes to thehedged portion of the cash flows of the Company’s variable-rate debtobligations.  The realized swap breakagecosts included in net income in the above table relate to the after-tax effectof swap breakage during the respective periods. The total pretax cost toterminate the swap contracts were $626,000 and $636,000 for the years endedDecember 31, 2002 and 2001, respectively, and are reflected as a component ofselling, general and administrative expenses in the Company’s Statement ofOperations.

 

**NOTE F.COMMITMENTS AND CONTINGENCIES**

 

The Company leases various office locations undernon-cancelable lease arrangements that have initial terms of one to six yearsand may provide renewal options from one to five years. Rent expense under alloperating leases was $916,000, $875,000, and $828,000 for 2002, 2001, and 2000,respectively.

 

Future minimum lease payments under non-cancelableoperating leases as of December 31, 2002 are as follows:

 

| **(in  thousands)** |   |   |   |
|---------------------|--------|--------|--------|
| 2003                |   | $      | 777    |   |
| 2004                |   | 339    |   |
| 2005                |   | 34     |   |
| Thereafter          |   | — |   |
| Total               |   | $      | 1,150  |   |

 

Although the Company is from time to time subjectto actions or claims for damages in the ordinary course of its business andengages in collection proceedings with respect to delinquent accounts, theCompany is aware of no such actions, claims, or proceedings currently pendingor threatened that are expected to have a material adverse effect on theCompany’s business, operating results or financial condition.

 

14

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**NOTE G. INCOMETAXES**

 

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

 

Incometax expense (benefit) is as follows: 

 
|                                 |   | **Year Ended December 31,** |   |
|--------------------------------------|--------|-----------------------------|--------|
| **(in  thousands)**                  |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                 |   |                        |   |   |   |   |   |
| Federal:                             |   |                        |   |   |   |   |   |
| Current                              |   | $                           | 34     |   | $ | 73 |   | $ | 7 |   |
| Deferred                             |   | 2,297                       |   | 1,237 |   | (318 | ) |
| State:                               |   |                        |   |   |   |   |   |
| Current                              |   | 8                           |   | 74 |   | 826 |   |
| Deferred                             |   | 552                         |   | 228 |   | (906 | ) |
|                                 |   |                        |   |   |   |   |   |
| Provision (benefit) for income taxes |   | $                           | 2,891  |   | $ | 1,612 |   | $ | (391 | ) |

 

A reconciliation of the U.S. federal statutoryincome tax rate and the effective tax rate as a percentage of pre-tax incomefor each year is as follows:

 
|                                               |   | **Year Ended December 31,** |   |
|----------------------------------------------------|--------|-----------------------------|--------|
|                                               |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                               |   |                        |   |   |   |   |   |
| Statutory rate                                     |   | 34.0                        | %      | 34.0 | % | 34.0 | % |
| State taxes net of U.S. federal income tax benefit |   | 5.1                         |   | 5.0 |   | 4.6 |   |
| Non-deductible expenses                            |   | 0.8                         |   | 1.4 |   | (4.1 | ) |
|                                               |   | 39.9                        | %      | 40.4 | % | 34.5 | % |

 

The items comprising a significant portion of netdeferred tax (assets) liabilities are as follows at December 31:

 
| **(in thousands)**                                             |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------|--------|----------|--------|----------|--------|
| Gross deferred tax liabilities:                                |   |     |   |     |   |
| Accounting for lease contracts and notes (Note 1)              |   | $        | 29,826 |     | $      | 26,932 |   |
|                                                           |   |     |   |     |   |
| Gross deferred tax assets:                                     |   |     |   |     |   |
| Net operating loss carryforwards and tax credit  carryforwards |   | (14,360  | )      | (14,349  | )      |
| Accrued expenses and other                                     |   | (2,254   | )      | (2,258   | )      |
| Tax effect of accumulated comprehensive loss (Note 2)          |   | (3,695   | )      | (2,813   | )      |
| Miscellaneous                                                  |   | (231     | )      | (194     | )      |
| Gross deferred tax assets                                      |   | (20,540  | )      | (19,614  | )      |
|                                                           |   |     |   |     |   |
| Net deferred income tax liability                              |   | $        | 9,286  |     | $      | 7,318 |   |

 

----

| Note 1: The deferred tax  liability from the accounting for leases and notes relates to temporary  differences between book and tax treatment of sold securitized direct  financing leases and notes.

Note 2: The tax effect of  accumulated comprehensive loss arises primarily from the recording of the  Company’s interest rate swap contracts on the balance sheet at fair value  (net of tax), pursuant to SFAS No. 133.  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

At December 31, 2002, the Company had federal andstate net operating loss carryforwards of approximately $35,100,000 and$52,800,000, respectively.  The federalnet operating loss carryforwards expire in the years 2018 through 2022, whilethe state net operating loss carryforwards expire in the years 2003 through2022.  At December 31, 2002, the Companyanticipates utilizing all its net operating loss carryforwards.

 

15

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

 

*Common Stock* - TheCompany has 15,000,000 shares authorized and 4,817,705 shares outstanding atDecember 31, 2002. Of the outstanding shares, 300,000 shares have been issuedto the Company’s ESOP (Note J) and 685,951 sharesare held in treasury.

 

*Preferred Stock* -The Company has 5,000,000 shares of $1.00 par value preferred stock authorizedwith no shares outstanding at December 31, 2002 or 2001.  (Note K, Preferred Stock Purchase RightsPlan.)

 

*Treasury Stock* -In December 2000, the Board of Directors approved an increase to the stockrepurchase program whereby the Company may repurchase up to an additional250,000 shares of the Company’s common stock subject to maximum dollarlimitations as set forth under the Company’s Foothill Revolver and SeniorSubordinated Note financing.  Based oncurrent market values at December 31, 2002 and the limitations as set forth inits most restrictive debt agreement, the Company may repurchase up to anadditional 129,000 shares of itscommon stock per year.  No time limithas been established for the repurchase program. The Company expects to use therepurchased stock to meet current and future requirements of its employee stockplans. During 2002, the Company repurchased 70,186 shares of its common stockfor approximately $538,000.

 

*Earnings per Share*– The Company’s basic net income per share calculation is based on theweighted-average number of common shares outstanding, which does not includeunallocated shares under the Company’s ESOP (Note J), restricted shares issuedunder the Stock Plans (Note I), treasury stock, or any shares issuable upon theexercise of outstanding stock options. Diluted net income per share includes the weighted-average number ofcommon shares subject to stock options and contingently issuable restrictedstock as calculated under the treasury stock method, but not treasury stock orunallocated shares under the Company’s ESOP. The stock options and contingently issuable restricted shares wereexcluded from the computation of diluted earnings per share (“EPS”) for 2000because their inclusion would have had an antidilutive effect on EPS.

 

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

 
|                                                    |   | **Year Ended December 31,** |   |
|---------------------------------------------------------|--------|-----------------------------|--------|
| **(in thousands, except per share  and share amounts)** |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                                    |   |                        |   |   |   |   |   |
| Basic net income (loss) per share:                      |   |                        |   |   |   |   |   |
| Net income (loss)                                       |   | $                           | 4,346  |   | $ | 2,379 |   | $ | (739 | ) |
|                                                    |   |                        |   |   |   |   |   |
| Weighted-average common shares outstanding              |   | 4,064,404                   |   | 3,965,378 |   | 3,879,496 |   |
|                                                    |   |                        |   |   |   |   |   |
| Basic net income (loss) per share                       |   | $                           | 1.07   |   | $ | 0.60 |   | $ | (0.19 | ) |
|                                                    |   |                        |   |   |   |   |   |
| Diluted net income (loss) per share:                    |   |                        |   |   |   |   |   |
| Net income (loss)                                       |   | $                           | 4,346  |   | $ | 2,379 |   | $ | (739 | ) |
|                                                    |   |                        |   |   |   |   |   |
| Weighted-average common shares outstanding              |   | 4,064,404                   |   | 3,965,378 |   | 3,879,496 |   |
| Stock options and restricted shares                     |   | 275,442                     |   | 354,295 |   | — |   |
| Total diluted shares                                    |   | 4,339,846                   |   | 4,319,673 |   | 3,879,496 |   |
|                                                    |   |                        |   |   |   |   |   |
| Diluted net income (loss) per share                     |   | $                           | 1.00   |   | $ | 0.55 |   | $ | (0.19 | ) |

 

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

 

*Stock Option Plans_*The following is a historical summary of theCompany’s various stock option plans for which stock options remain outstandingat December 31, 2002:

 
| **Stock Option Plan Name**                            |   | **Plan  Inception Date** |   | **Plan  Termination Date (if applicable)**     |   |
|-------------------------------------------------------|--------|--------------------------|--------|------------------------------------------------|--------|
| 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               |   | May 2002, upon approval of the  2002 Plan      |   |
| 2002 Stock Incentive Plan (the “2002 Plan”) |   | May 2002                 |   |                                           |   |

 

16

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*1986 Plan and1994 Plan*_  Options granted under the 1986 Plan and the1994 Plan are non-qualified stock options granted at an exercise price equal tothe market price of the common stock on the date of grant.

 

*1995 Plan_*Upon approval of the 1995 Plan in May 1995, 550,000 shares were initiallyreserved for the issuance of stock options or awards of restricted stock.  Options outstanding under the 1995 Plan areeither incentive stock options or non-qualified stock options granted at anexercise price equal to the market price of the Company’s common stock on thedate of the grant. Restricted shares of common stock were awarded under the1995 Plan and remained unvested until certain performance and serviceconditions were both met.

 

A summary of restricted stock awards issuedpursuant to the 1995 Plan 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    |       | May  2002    |       |

 

Note 1: In April 1998, 150,000 outstandingrestricted shares were forfeited in exchange for stock options granted pursuantto the 1995 Plan.

 

At the time each restricted stock award wasgranted, the Company recorded additional paid-in capital and deferredcompensation in an amount equal to the number of shares granted multiplied bythe respective performance condition price per share.  Compensation expense was 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 performance conditionwas met.  In 2002, 2001, and 2000, theCompany recognized $94,000, $225,000, and $268,000, respectively, incompensation expense related to restricted stock awards under its 1995 Plan.All remaining restricted shares from the 1995 Plan were distributed in May 2002upon achieving the required service condition.

 

*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 Company’s common stock on each of the days on which the stock wastraded during the 30-calendar day period ending on the day before the date ofthe option grant. No restricted shares were awarded under the 1998 Plan.

 

*2000 Plan_*Upon the approval of the 2000 Plan in April 2000, 450,000 shares of theCompany’s common stock were reserved for the issuance of stock options orrestricted stock awards.  In addition,shares subject to options or stock awards under the 1998 Plan that expire orare terminated unexercised were made available for issuance as stock options orrestricted stock awards under the 2000 Plan. The 2000 Plan provides that with respect to options granted to keyemployees (except non-employee directors), the option term and the terms andconditions upon which the option may be exercised are to be determined by theCompensation Committee of the Company’s Board of Directors for each such optionat the time it is granted. Options granted to key employees of the Company areeither incentive stock options or non-qualified options, as designated by theCompensation Committee, at an exercise price not to be less than the closingprice of the Company’s common stock on the date of the option grant.  No restricted shares were awarded under the2000 Plan.

* *

*2002 Plan_*Upon the approval of the 2002 Plan in May 2002, 200,000 shares of theCompany’s common stock were reserved for the issuance of stock options and restrictedstock awards.  In addition, sharessubject to options or stock awards under the 2000 Plan that expire or areterminated unexercised are made available for issuance as stock options orrestricted stock awards under the 2002 Plan. The 2002 Plan provides that with respect to options granted to keyemployees (except non-employee directors), the option term and the terms andconditions upon which the options may be exercised are to be determined by theCompensation Committee of the Company’s Board of Directors for each such optionat the time it is granted. Options granted to key employees of the Company areeither incentive stock options or non-qualified options, as designated by theCompensation Committee, at an exercise price not to be less than 85% of theclosing price of the Company’s common stock on the date of the optiongrant.  As of December 31, 2002, norestricted shares have been awarded under the 2002 Plan.

 

Each non-employee director who was such at theconclusion of any regular annual meeting of the Company’s stockholders whilethe 2002 Plan is in effect and who continues to serve on the Board of Directorsis granted automatic options to purchase 1,000

 

17

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shares of the Company’s common stock at an exercise price equal to theclosing price of the Company’s common stock on the date of the option grant.Each automatic option is exercisable immediately in full or for any portionthereof and remains exercisable for 10 years after the date of grant, unlessterminated earlier (as provided in the 2002 Plan) upon or following terminationof the holder’s service as a director.

 

As of December 31, 2002, the Company had granted79,000 stock options and no restricted stock awards pursuant to the 2002 Plan.

 

The following table summarizes stock option andrestricted stock activity under all the plans combined:

 
|                                       |   | **Options**            |   |                                      |   |
|--------------------------------------------|--------|------------------------|--------|-------------------------------------------|--------|
|                                       |   | **Number of  Options** |   | **Weighted-****Average  Exercise  Price** |   | **Restricted  Stock** | ** ** |
|                                       |   |                   |   |                                      |   |   |   |
| Outstanding at January 1, 2000             |   | 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 |   |
| Granted                                    |   | 105,000                |   | 8.13                                      |   | — |   |
| Exercised                                  |   | (32,175                | )      | 3.77                                      |   | — |   |
| Forfeited                                  |   | (20,700                | )      | 4.54                                      |   | — |   |
| Release of restriction on restricted stock |   | —                 |   | —                                    |   | (124,000 | ) |
|                                       |   |                   |   |                                      |   |   |   |
| Outstanding at December 31, 2002           |   | 1,466,500              |   | $ 6.04                                    |   | — |   |

 

The following table sets forth informationregarding options outstanding at December 31, 2002:

 
|                           |   | **Options Outstanding** |   | **Options Exercisable**                                  |   |
|--------------------------------|--------|-------------------------|--------|----------------------------------------------------------|--------|
| **Range of  Exercise  Prices** |   | **Number of  Options**  |   | **Weighted-Average  Remaining Contractua  Life (Years)** |   | **Weighted-  Average  Exercise Price** |   | **Number of  Options** |   | **Weighted-Average  Exercise Price** |   |
|                           |   |                    |   |                                                     |   |   |   |   |   |   |   |
| $2.62 - 3.25                   |   | 195,000                 |   | 0.4                                                      |   | $ 2.87 |   | 195,000 |   | $ | 2.87 |   |
| $3.56 - 4.75                   |   | 35,500                  |   | 2.0                                                      |   | 4.25 |   | 35,500 |   | 4.25 |   |
| $5.12 - 5.37                   |   | 555,500                 |   | 5.3                                                      |   | 5.30 |   | 551,000 |   | 5.30 |   |
| $6.00 - 6.90                   |   | 160,000                 |   | 7.9                                                      |   | 6.30 |   | 72,500 |   | 6.31 |   |
| $7.50 - 7.95                   |   | 319,500                 |   | 7.3                                                      |   | 7.51 |   | 187,500 |   | 7.52 |   |
| $8.00 - 8.83                   |   | 126,000                 |   | 7.6                                                      |   | 8.62 |   | 42,300 |   | 8.62 |   |
| $9.00 - 9.85                   |   | 75,000                  |   | 7.4                                                      |   | 9.50 |   | 48,000 |   | 9.54 |   |
|                           |   |                    |   |                                                     |   |   |   |   |   |   |   |
| $2.62 - 9.85                   |   | 1,466,500               |   | 5.6                                                      |   | $ 6.04 |   | 1,131,800 |   | $ | 5.58 |   |

 

The weighted-average grant date fair values of options granted for theyears ended December 31, 2002, 2001, and 2000 were $3.77, $3.06, and $5.84, respectively.

 

*1998 Outside Directors Stock Bonus Plan_*Under the terms of the 1998 Outside DirectorsStock Bonus Plan, the Company will award 1,000 bonus shares of common stock toeach non-employee director who is such at the beginning of any regular annual

 

18

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stockholdersmeeting while the 1998 Outside Directors Stock Bonus Plan is in effect and whowill continue to serve on the Board of Directors.  Bonus shares are issued in consideration of services previouslyrendered to the Company. At the time bonus shares are issued, the Companyrecognizes compensation expense equal to the fair value of the shares issued.The Company amended the 1998 Outside Directors Stock Bonus Plan in 2001 toincrease the number of shares reserved under the Plan from 25,000 to50,000.  On a cumulative basis throughDecember 31, 2002, the Company has issued 31,000 shares of common stockpursuant to the 1998 Outside Directors Stock Bonus Plan.

 

*NotesReceivable from Officers and Employees (*“*Stock Loan Program*”*)_*The Company maintained aStock Loan Program until December 13, 2002 pursuant to which executive officersand other senior personnel of the Company could borrow from the Company for thepurpose of acquiring common stock of the Company, to pay the exercise price ofoptions and to pay any taxes, including alternative minimum taxes, payable uponthe exercise of options or the vesting of restricted stock.  As of December 13, 2002, no future loanswill be made to executive officers, as required by the Sarbanes-Oxley Act of2002. Loans outstanding at December 13, 2002 remain payable in accordance withtheir terms. All outstanding loans at December 2002 provide for periodicprincipal repayments in an amount equal to 20% of the participant’s after-taxbonus.  A portion of any sharespurchased with such loans are pledged to the Company as collateral forrepayment of the loans. The Stock Loan Program was amended in October 2001 toprovide that all loans under the program be forgiven upon a “change of control”of the Company as defined in the 2000 Plan. In June 2002, the Company made oneloan to an executive officer in the amount of $79,000.

 

*2001Supplemental Executive Bonus Plan_* In October 2001, the Compensation Committee of the Board of Directorsadopted the 2001 Supplemental Executive Bonus Plan which permits the Committee,in its discretion, to award supplemental bonuses to key executives in an amountup to 20% of the executive’s annual bonus. No such supplemental bonus shall be awarded to an executive unless he orshe has an outstanding loan under the Company’s Stock Loan Program and not inexcess of the 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.  During 2002, the Company paid $93,200 insupplemental bonuses under the 2001 Supplemental Executive Bonus Plan.

 

**NOTE J. EMPLOYEEBENEFIT PLANS**

 

*Employee StockOwnership Plan_*In 1993,the Company established an Employee Stock Ownership Plan (“ESOP”) for thebenefit of all eligible employees. The ESOP invests in common stock of theCompany on behalf of the employees. ESOP contributions are at the discretion ofthe Company’s Board of Directors and are determined annually. However, it isthe Company’s intention to make contributions sufficient to repay the ESOP’spromissory note on a level-funding basis over a 10-year period. The Company measuresthe expense related to such contributions based on the annual average fairvalue of the stock contributed. The spread between the average fair value ofthe stock contribution and the original cost of the stock when issued to theESOP is recorded as additional paid-in capital in the year to which thecontribution relates. Principal repayments on the promissory note were $105,000in each of 2002, 2001, and 2000.

 

Employeeswith five or more years of service with the Company at the time of terminationof employment will be fully vested in their benefits under the ESOP. For aparticipant with fewer than five years of service at the time of termination,his or her account balance will vest at the rate of 20% for each year ofemployment. Upon the retirement or other termination of an ESOP participant,the shares of common stock in which he or she is vested may, at the option ofthe participant, be converted to cash or distributed. Any unvested shares areallocated to the remaining participants. The Company issued 300,000 shares ofcommon stock to this plan in consideration of a promissory note in the originalprincipal amount of $1,050,000. As of December 31, 2002, the remainingprincipal balance of the note is $106,000, which is recorded as a component ofdeferred compensation in stockholders’ equity. Since inception of the ESOP,265,426 shares of common stock have been allocated to participant accounts and34,574 shares remain unallocated. The market value of the unallocated shares atDecember 31, 2002 was approximately $268,000.

 

*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 $164,000, $141,000 and $128,000 in 2002, 2001 and 2000,respectively.

 

*SupplementalExecutive Retirement Plan*_In 1997, the Company adopted an unfunded Supplemental Executive Retirement Plan(the “SERP”).  The SERP provides certainexecutives with retirement income benefits intended to supplement other retirementbenefits available to the executives. Benefits under the plan, based on an actuarial equivalent of a lifeannuity, are based on age, length of service and average earnings and vest over15 years, assuming five years of service. Benefits are payable upon separation of service.

 

19

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Detailsof the SERP for the years ended December 31, 2002 and 2001 are as follows:

** **
| **(in  thousands)**                                                    |   | **2002** |       | **2001** |       |
|------------------------------------------------------------------------|--------|----------|------------|----------|------------|
| **Change in benefit obligation:**                                      |   |     |       |     |       |
| Benefit obligation, beginning of year                                  |   | $        | 3,416      |     | $          | 2,681 |   |
| Service cost                                                           |   | 336      |       | 291      |       |
| Interest cost                                                          |   | 244      |       | 223      |       |
| Actuarial loss                                                         |   | 278      |       | 221      |       |
| Benefit obligation, end of year                                        |   | 4,274    |       | 3,416    |       |
|                                                                   |   |     |       |     |       |
| **Funded status and statement of financial position:**                 |   |     |       |     |       |
| Fair value of assets, end of year                                      |   | —   |       | —   |       |
| Benefit obligation, end of year                                        |   | 4,274    |       | 3,416    |       |
| Funded status                                                          |   | (4,274   | )          | (3,416   | )          |
| Unrecognized actuarial loss                                            |   | 714      |       | 456      |       |
| Unrecognized prior service cost                                        |   | 1,032    |       | 1,156    |       |
| Net accrued benefit cost                                               |   | (2,528   | )          | (1,804   | )          |
|                                                                   |   |     |       |     |       |
| Amounts recognized in the statement of financial  position consist of: |   |     |       |     |       |
| Accrued benefit liability included in accrued  liabilities             |   | (3,103   | )          | (2,327   | )          |
| Intangible assets included in other assets                             |   | 575      |       | 523      |       |
| Net accrued benefit cost                                               |   | (2,528   | )          | (1,804   | )          |
|                                                                   |   |     |       |     |       |
| **Components of net periodic benefit costs:**                          |   |     | ** ** |     | ** ** |
| Service cost                                                           |   | 336      |       | 291      |       |
| Interest cost                                                          |   | 244      |       | 223      |       |
| Amortization of prior service cost                                     |   | 124      |       | 124      |       |
| Recognized actuarial loss                                              |   | 20       |       | 18       |       |
| Net periodic benefit cost                                              |   | $        | 724        |     | $          | 656 |   |

** **
|                                             |   | **2002** |       | **2001** |       |
|--------------------------------------------------|--------|----------|------------|----------|------------|
| **Weighted-average assumptions:**                |   |     | ** ** |     | ** ** |
| For pension cost and year end benefit obligation |   |     |       |     |       |
| Discount rate                                    |   | 6.50     | %          | 7.00     | %          |
| Compensation increase                            |   | 4.00     | %          | 4.00     | %          |
| Assumed retirement age                           |   | 65 years | 65 years   |

 

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

 

Pursuantto a rights agreement between the Company and Fleet National Bank, as rightsagent, dated August 1993 and amended and restated in September 1999, the Boardof Directors declared a dividend in August 1993 of one preferred stock purchaseright (“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. The Rights beneficially owned by the Acquiring Person and its affiliatesbecome null and void upon the Rights becoming exercisable.

 

If aperson becomes an Acquiring Person or certain other events occur, each Rightentitles the holder, other than the Acquiring Person, to purchase common stock(or one one-hundredth of a share of preferred stock, at the discretion of theBoard of Directors) having a market value of two times the exercise price ofthe Right.  If the Company is acquiredin a merger or other business combination, each exercisable Right entitles theholder, other than the Acquiring Person, to purchase common stock of theacquiring company having a market value of two times the exercise price of theRight.

 

20

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Atany time after a person becomes an Acquiring Person and prior to theacquisition by such person of 50% or more of the outstanding common stock, theBoard of Directors may direct the Company to exchange the Rights held by anyperson other than an Acquiring Person at an exchange ratio of one share ofcommon stock per Right.  The Rights maybe redeemed by the Company, subject to approval by the Board of Directors, forone cent per Right in accordance with the provisions of the Rights Plan.  The Rights have no voting or dividendprivileges.

 

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

 

Thefair value of a financial instrument is the amount at which the instrumentcould be exchanged in a current transaction between willing parties, other thanin a forced or liquidation sale.

 

Quotedmarket prices are used when available; otherwise, management estimates fairvalue based on prices of financial instruments with similar characteristics orusing valuation techniques such as discounted cash flow models. Valuationtechniques involve uncertainties and require assumptions and judgmentsregarding prepayments, credit risk and discount rates. Changes in theseassumptions will result in different valuation estimates. The fair valuespresented would not necessarily be realized in an immediate sale, nor are thereplans to settle liabilities prior to contractual maturity. Valuation techniquesvary, therefore, it may be difficult to compare the Company’s fair value informationto other companies’ fair value information.

 

Thefollowing table presents a comparison of the carrying value and estimated fairvalue of the Company’s financial instruments at December 31, 2002 and 2001:

 
|                                                                                 |   | **2002**            |       | **2001**                  |       |
|--------------------------------------------------------------------------------------|--------|---------------------|------------|---------------------------|------------|
| **(in  thousands)**                                                                  |   | **Carrying  Value** |       | **Estimated  Fair Value** |       | **Carrying  Value** |   | **Estimated  Fair Value** |   |
|                                                                                 |   |                |       |                      |       |   |   |   |   |
| Financial assets:                                                                    |   |                |       |                      |       |   |   |   |   |
| Cash and cash equivalents                                                            |   | $                   | 51         |                      | $          | 51 |   | $ | 698 |   | $ | 698 |   |
| Restricted cash                                                                      |   | 29,633              |       | 29,633                    |       | 28,786 |   | 28,786 |   |
| **Net investment in leases and notes**                                               |   | **458,034**         | ** ** | **460,561**               | ** ** | **396,996** | ** ** | **398,227** | ** ** |
| 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** |   | **406,264**         | ** ** | **390,331**               | ** ** | **356,791** | ** ** | **369,342** | ** ** |
| Interest rate swap contracts (Note 1)                                                |   | 9,406               |       | 9,406                     |       | 7,230 |   | 7,230 |   |
|                                                                                      |        |                     |            |                           |            |  |  |  |  |  |  |  |  |

 

----

Note 1:  SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities”, which became effective forthe Company on January 1,2001, requires all derivative instruments to berecorded on the balance sheet as either assets or liabilities at theirestimated fair value.

 

Interestrate swap contracts reflect the marked-to-market valuation of the swaps hedgingon-balance sheet debt obligations of the Company. In addition to the swapslisted above, the Company has assigned portions of interest rate swap contractsto third parties in connection with sales of leases and notes receivable (NotesC and E). The estimated fair value of interest rate swap contracts****assignedto third parties which are not recorded on the Company’s consolidated balancesheet was a liability of $16,954,000and $8,864,000 at December 31, 2002 and2001, respectively.

 

Thefollowing methods and assumptions were used to estimate the fair value of eachclass of financial instrument:

 

Cash, cash equivalents andrestricted cash: For these short-term instruments, the carrying amount is areasonable estimate of fair value.

 

Net investment in leases andnotes: The fair value was estimated by discounting the anticipated future cashflows using current rates applied to similar contracts.  The fair value of impaired loans isestimated by discounting management’s estimate of future cash flows with a discountrate commensurate with the risk associated with such assets.

 

Notes payable and subordinateddebt: The fair market value of the Company’s senior and subordinated notes isestimated based on the quoted market prices for similar issues or on thecurrent rates offered to the Company for debt of similar maturities.

 

21

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Interest rate swap contracts: Thefair value of interest rate swap contracts is based on the estimated amount dueupon 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-payout leases or notes due in installments.  Asset-based financing includes revolving lines of credit tocommercial and industrial companies in the form of notes receivablecollateralized by accounts receivable, inventory and/or fixed assets. During2002, the Company ceased originating new asset based loans in its ACFCcommercial and industrial financing segment. The licensed professionalfinancing segment derives its revenues primarily from earnings on fixed-rateleases and notes, whereas revenues from the commercial and industrial financingsegment are derived predominantly from borrowings under variable-rate notesissued under the lines of credit plus miscellaneous commitment andperformance-based fees.

 

In June 2002, the Company discoveredthat an employee of its asset-based financing segment had perpetrated adefalcation of approximately $5 million over a period of 5 years.  In August 2002, the Company filed with theSecurities and Exchange Commission amended annual and quarterly reportscontaining restated financial statements reflecting the losses in the periodsthey occurred.

 

### **On December 31, 2002, the Company’sasset-based financing segment sold five revolving loans to a third party. Atthe time of the sale, the loans had a net book value of $7,426,000. The Companyreceived proceeds of $6,683,000, plus accrued and unpaid interest to the datethereon, and incurred a pre-tax loss of $743,000.**

 

*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 taxprovision.  The Company does notallocate corporate overhead to its asset-based financing segment sincesubstantially all such overhead relates to the licensed professional financingsegment.

 

A summary of information about the Company’s operations by operating segmentfor the years ended December 31, 2002, 2001, and 2000 is as follows:

 
| **(in thousands)**                           |   | **Licensed  Professional  Financing** |   | **Commercial  and  Industrial  Financing** |   | **Total** |   |
|----------------------------------------------|--------|---------------------------------------|--------|--------------------------------------------|--------|-----------|--------|
| **2002**                                     |   |                                  |   |                                       |   |      |   |
| Earned income on leases and notes            |   | $                                     | 48,300 |                                       | $      | 2,654     |   | $ | 50,954 |   |
| Gain (loss) on sales of leases and notes     |   | 16,547                                |   | (743                                       | )      | 15,804    |   |
| Provision for losses                         |   | (9,653                                | )      | (1,795                                     | )      | (11,448   | )      |
| Selling, general and administrative expenses |   | (20,248                               | )      | (2,032                                     | )      | (22,280   | )      |
| Loss from employee defalcation               |   | —                                |   | (448                                       | )      | (448      | )      |
| Net profit contribution                      |   | 34,946                                |   | (2,364                                     | )      | 32,582    |   |
|                                         |   |                                  |   |                                       |   |      |   |
| Total assets                                 |   | 483,693                               |   | 13,449                                     |   | 497,142   |   |
|                                         |   |                                  |   |                                       |   |      |   |
| **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   | )      |
| Loss from employee defalcation               |   | —                                |   | (1,379                                     | )      | (1,379    | )      |
| Net profit contribution                      |   | 29,657                                |   | 327                                        |   | 29,984    |   |
|                                         |   |                                  |   |                                       |   |      |   |
| Total assets                                 |   | 407,702                               |   | 28,671                                     |   | 436,373   |   |
|                                         |   |                                  |   |                                       |   |      |   |
| **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   | )      |
| Loss from employee defalcation               |   | —                                |   | (1,361                                     | )      | (1,361    | )      |
| Net profit contribution                      |   | 22,644                                |   | 1,430                                      |   | 24,074    |   |
|                                         |   |                                  |   |                                       |   |      |   |
| Total assets                                 |   | 461,654                               |   | 31,976                                     |   | 493,630   |   |
|                                              |        |                                       |        |                                            |        |           |        |  |  |  |

 

22

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

 
| **(in thousands)**                |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                              |   |     |   |     |   |     |   |
| Net segment profit contribution   |   | $        | 32,582 |     | $      | 29,984   |   | $ | 24,074 |   |
| Interest expense                  |   | (25,773  | )      | (27,872  | )      | (26,222  | )      |
| Interest income                   |   | 428      |   | 1,879    |   | 1,018    |   |
| Income (loss) before income taxes |   | $        | 7,237  |     | $      | 3,991    |   | $ | (1,130 | ) |

 

*OtherSegment Information* - The Company derives substantially allof its revenues from domestic customers. As of December 31, 2002 and 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 than21% and 10%, respectively, of the total portfolio in that segment.  The licensed professional financing segmentrelies on certain vendors to provide referrals to the Company, but for the yearended December 31, 2002 and 2001, no one vendor accounted for greater than 7%of the Company’s lease and loan originations.

 

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

 

Selectedquarterly consolidated financial data (unaudited) for the years ended December31, 2002 and 2001 are as follows:

 
|                                         |   | **Three Months Ended** |   |
|----------------------------------------------|--------|------------------------|--------|
| **(in thousands, except per share amounts)** |   | **March 31**           |   | **June 30** |   | **September 30** |   | **December 31** |   |
| **Year 2002**                                |   |                   |   |   |   |   |   |   |   |
| Revenues:                                    |   |                   |   |   |   |   |   |   |   |
| Earned income on leases and notes            |   | $                      | 12,213 |   | $ | 12,789 |   | $ | 12,873 |   | $ | 13,079 |   |
| Gain on sales of leases and notes            |   | 2,068                  |   | 3,839 |   | 4,884 |   | 5,013 |   |
| Provision for losses                         |   | (1,780                 | )      | (2,806 | ) | (3,844 | ) | (3,018 | ) |
| Net Revenues                                 |   | 12,501                 |   | 13,822 |   | 13,913 |   | 15,074 |   |
|                                         |   |                   |   |   |   |   |   |   |   |
| Operating and Other Expenses:                |   |                   |   |   |   |   |   |   |   |
| Selling, general and administrative          |   | 4,958                  |   | 5,566 |   | 5,316 |   | 6,440 |   |
| Loss from employee defalcation               |   | 291                    |   | 157 |   | — |   | — |   |
| Interest expense (net)                       |   | 5,868                  |   | 6,347 |   | 6,615 |   | 6,515 |   |
|                                         |   |                   |   |   |   |   |   |   |   |
| Income before Income Taxes                   |   | 1,384                  |   | 1,752 |   | 1,982 |   | 2,119 |   |
| Provision for Income Taxes                   |   | 560                    |   | 702 |   | 795 |   | 834 |   |
| Net Income                                   |   | $                      | 824    |   | $ | 1,050 |   | $ | 1,187 |   | $ | 1,285 |   |
|                                         |   |                   |   |   |   |   |   |   |   |
| Basic Net Income per Share                   |   | $                      | 0.21   |   | $ | 0.26 |   | $ | 0.29 |   | $ | 0.31 |   |
| Diluted Net Income per Share                 |   | $                      | 0.19   |   | $ | 0.24 |   | $ | 0.27 |   | $ | 0.29 |   |
|                                         |   |                   |   |   |   |   |   |   |   |
| **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 |   |
| Loss from employee defalcation               |   | 408                    |   | 345 |   | 105 |   | 521 |   |
| Interest expense (net)                       |   | 6,555                  |   | 7,036 |   | 6,453 |   | 5,949 |   |
|                                         |   |                   |   |   |   |   |   |   |   |
| Income before Income Taxes                   |   | 1,019                  |   | 454 |   | 1,556 |   | 962 |   |
| Provision for Income Taxes                   |   | 424                    |   | 186 |   | 619 |   | 383 |   |
| Net Income                                   |   | $                      | 595    |   | $ | 268 |   | $ | 937 |   | $ | 579 |   |
|                                         |   |                   |   |   |   |   |   |   |   |
| Basic Net Income per Share                   |   | $                      | 0.15   |   | $ | 0.07 |   | $ | 0.24 |   | $ | 0.15 |   |
| Diluted Net Income per Share                 |   | $                      | 0.14   |   | $ | 0.06 |   | $ | 0.22 |   | $ | 0.13 |   |

 

23

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### **NOTE 0. SUBSEQUENT EVENTS**

 

On January 29, 2003, the MBIA portion of the BravoFacility was amended to increase availability to the Company temporarily from$450,000,000 to $525,000,000.  Theincreased liquidity expires upon the earlier to occur of the completion by theCompany of a new term securitization transaction (described below) or April 30,2003.  In addition, the Company’scontinued use of the Bravo Facility is contingent upon the Company’s obtainingan additional securitization conduit facility with a third party (similar innature to the Bravo Facility).  Theamendment requires that the new conduit facility, which must be arranged byJune 23, 2003, provide the Company with availability of at least $150,000,000.

 

On January 31, 2003, the HPSC Foothill Revolver wasamended to increase availability temporarily from $50,000,000 to $60,000,000,through April 24, 2003.  In addition,the amendment permits the Company to borrow up to $750,000 in the HPSC FoothillRevolver to finance the operations of its ACFC subsidiary.  On February 5, 2003, the Company borrowed$276,000 from the HPSC Foothill Revolver for the purpose of paying off theremaining outstanding balance of the ACFC Foothill Revolver.

 

OnMarch 31 2003, the Company completed a $323,190,000 private placement termsecuritization.  In conjunction with thesecuritization, the Company created two new special-purpose entities, HPSCGloucester Funding 2003-1 LLC I (GF 2003-1 LLC I) and HPSC Gloucester Funding2003-1 LLC II (GF 2003-1 LLC II). The initial financing contracts contributedto the securitization were transferred by HPSC and Bravo to GF 2003-1 LLCII.  Proceeds from the note offeringwere used to pay down amounts outstanding in both the MBIA and ING portions ofthe Bravo Facility.  In addition, approximately15% of the total proceeds from the notes were set aside in a restrictedprefunding account for the purpose of acquiring future financing contracts fromthe Company.

 

24

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**INDEPENDENT AUDITORS’ 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, 2002 and 2001, 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, 2002. 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 material misstatement.An audit includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements. An audit also includes assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat 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, 2002 and 2001, and the results of their operations and theircash flows for each of the three years in the period ended December 31, 2002,in conformity with accounting principles generally accepted in the United Statesof America.

 

As discussed in Note A to the accompanyingconsolidated financial statements, effective January 1, 2001, the Companyadopted the provisions of Statement of Financial Accounting Standards No. 133, “Accountingfor Derivative Instruments and Hedging Activities”.

 

 
| /s/ Deloitte & Touche LLP |   |
|-------------------------------|--------|
| Boston, Massachusetts         |
|                          |
| **March 31, 2003**            |

 

25

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**MARKET INFORMATION**

 

The Company’s commonstock is traded on the American Stock Exchange (Symbol: “HDR”).  The table below sets forth therepresentative high and low closing prices for shares of the common stock ofthe Company as reported by the American Stock Exchange for the fiscal years2002 and 2001:

 
| **2002 Fiscal Year** |   | **High** |   | **Low** |   | **2001  Fiscal Year** |   | **High** |   | **Low** |   |
|----------------------|--------|----------|--------|---------|--------|-----------------------|--------|----------|--------|---------|--------|
|                 |   |     |   |    |   |                  |   |     |   |    |   |
| First Quarter        |   | $ 7.30   |   | $ 6.51  |   | First Quarter         |   | $ 6.75   |   | $ 6.00  |   |
| Second Quarter       |   | 10.00    |   | 6.60    |   | Second Quarter        |   | 8.80     |   | 6.50    |   |
| Third Quarter        |   | 9.16     |   | 8.30    |   | Third Quarter         |   | 8.45     |   | 6.80    |   |
| Fourth Quarter       |   | 8.25     |   | 7.70    |   | Fourth Quarter        |   | 8.15     |   | 6.50    |   |

 

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 21, 2003)** |
|-----------------------------------------|--------|---------------------------------------------------------------------|
|                                    |   |                                                                |
| Common Stock, par value  $.01 per share |   | 81(1)                                                               |

 

----

(1) This number does notreflect beneficial ownership of shares held in “nominee” or “street name.”

 

**Dividends**

 

The Company has neverpaid any dividends and anticipates that, for the foreseeable future, itsearnings will be retained for use in its business.

 

26

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**SELECTED FINANCIAL DATA**

* *
|                                                                        |   | **Year Ended**     |   |
|-----------------------------------------------------------------------------|--------|--------------------|--------|
| **(in thousands, except  share and per share data)**                        |   | **Dec. 31,  2002** |   | **Dec. 31,  2001** |   | **Dec. 31,  2000(4)** |   | **Dec.31,  1999** |   | **Dec. 31,  1998** |   |
|                                                                        |   |               |   |   |   |   |   |   |   |   |   |
| **Statement of Operations Data**                                            |   |               |   |   |   |   |   |   |   |   |   |
|                                                                        |   |               |   |   |   |   |   |   |   |   |   |
| Revenues:                                                                   |   |               |   |   |   |   |   |   |   |   |   |
| Earned income on  leases and notes                                          |   | $                  | 50,954 |   | $ | 47,970 |   | $ | 49,462 |   | $ | 40,551 |   | $ | 33,258 |   |
| Gain on sales of  leases and notes                                          |   | 15,804             |   | 14,928 |   | 12,078 |   | 4,916 |   | 4,906 |   |
| Provision for  losses                                                       |   | (11,448            | )      | (9,409 | ) | (9,218 | ) | (4,489 | ) | (4,201 | ) |
| Net Revenues                                                                |   | 55,310             |   | 53,489 |   | 52,322 |   | 40,978 |   | 33,963 |   |
| Net Income  (Loss)                                                          |   | $                  | 4,346  |   | $ | 2,379 |   | $ | (739 | ) | $ | 2,273 |   | $ | 1,895 |   |
| Net Income  (Loss) per Share — Basic(1)                                |   | $                  | 1.07   |   | $ | 0.60 |   | $ | (0.19 | ) | $ | 0.60 |   | $ | 0.51 |   |
| — Diluted(1)                                                           |   | $                  | 1.00   |   | $ | 0.55 |   | $ | (0.19 | ) | $ | 0.51 |   | $ | 0.45 |   |
| Shares Used to  Compute        —Basic(1) |   | 4,064,404          |   | 3,965,378 |   | 3,879,496 |   | 3,766,684 |   | 3,719,026 |   |
| Net Income  (Loss) per Share —Diluted(1)                               |   | 4,339,846          |   | 4,319,673 |   | 3,879,496 |   | 4,436,476 |   | 4,194,556 |   |

 
| **(in thousands)**                                |   | **Dec. 31,  2002** |   | **Dec. 31,  2001** |   | **Dec. 31,  2000** |   | **Dec. 31,  1999** |   | **Dec. 31,  1998** |   |
|---------------------------------------------------|--------|--------------------|--------|--------------------|--------|--------------------|--------|--------------------|--------|--------------------|--------|
|                                              |   |               |   |               |   |               |   |               |   |               |   |
| **Balance Sheet Data**                            |   |               |   |               |   |               |   |               |   |               |   |
|                                              |   |               |   |               |   |               |   |               |   |               |   |
| Cash and cash  equivalents                        |   | $                  | 51     |               | $      | 698                |   | $                  | — |               | $      | — |   | $ | 3,666 |   |
| Restricted  cash(2)                               |   | 29,633             |   | 28,786             |   | 115,085            |   | 14,924             |   | 9,588              |   |
| Lease and notes  receivable(3)                    |   | 561,510            |   | 488,376            |   | 455,139            |   | 446,699            |   | 344,836            |   |
| Unearned income                                   |   | 118,043            |   | 104,741            |   | 98,089             |   | 94,228             |   | 73,019             |   |
| Total Assets                                      |   | 497,142            |   | 436,373            |   | 493,630            |   | 386,572            |   | 298,956            |   |
| Revolving credit  borrowings                      |   | 43,437             |   | 52,000             |   | 49,000             |   | 70,000             |   | 49,000             |   |
| Senior notes,  net of discount                    |   | 344,867            |   | 284,806            |   | 355,461            |   | 227,445            |   | 174,541            |   |
| Subordinated  debt                                |   | 17,960             |   | 19,985             |   | 19,985             |   | 20,000             |   | 20,000             |   |
| Accumulated  other comprehensive loss, net of tax |   | 5,711              |   | 4,348              |   | —             |   | —             |   | —             |   |
| Total  Stockholders’ Equity                  |   | 39,841             |   | 36,781             |   | 38,752             |   | 39,106             |   | 36,800             |   |
|                                                   |        |                    |        |                    |        |                    |        |                    |        |                    |        |  |  |  |  |  |

 

----

 

(1) Net income per share for all periods presented conform to theprovisions of Statement of Financial Accounting Standards No. 128, “Earningsper 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 term securitization.

 

(3) Leases and notes receivable include the Company’s retained interestin leases and notes sold under sales and securitization agreements.

 

(4) Net income and basic and diluted net income per share for the yearended December 31, 2000 include one-time charges of $7,106,000 associated withcompleting the ER 2000-1 term securitization.

 

27

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**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**

 

**CRITICAL ACCOUNTING POLICIES**

 

The consolidatedfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States of America.  The preparation of financial statements requires management tomake certain estimates and assumptions that affect the reported amounts ofassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. The Companybelieves that, of its significant accounting policies (as discussed in Note Ato the notes to consolidated financial statements), the following may involve ahigher degree of judgment or complexity:

 

*Allowance for Losses*-  The allowance for losses is establishedthrough a charge to the provision for losses. Provisions are made to reservefor estimated future losses arising from the Company’s portfolio of lease andnote financing contracts. Each reporting period, the Company evaluates theadequacy of the allowance for losses and records an adjustment to the provisionfor losses to restore the allowance to designated levels. To evaluate theadequacy of the allowance for losses, the Company utilizes certain estimatesand assumptions. Management bases these estimates and assumptions on historicalexperience and on various other factors that they believe to be reasonableunder the circumstances.  Eachdelinquent customer account is carefully evaluated based on specific criteria,such as delinquency status, value of equipment or other collateral, creditbureau scores, financial condition of any guarantors, and recent paymentperformance of the obligor. In addition, the Company may factor in otherconsiderations such as historical charge-off rates, delinquency trends andgeneral economic conditions. Applying different estimates or assumptions couldpotentially produce materially different results from those reported by theCompany.

 

*Sales of Financing Contracts*-The Company periodically sells leases andnotes in its securitization facilities and to various banks. Gains on sales ofleases and notes are recognized in the consolidated statements of operationswhen the Company relinquishes control of the transferred financing contracts inaccordance with SFAS No. 140. The Company typically provides credit enhancementthrough the establishment of a retained interest in the financing contractssold. Recorded gains or losses upon the sale of financing contractsdepend, in part, on the fair value of the retained interest. The Company mustalso continually evaluate its retained interest in financing contracts sold forimpairment to its fair value. These routine fair value calculations requiremanagement to utilize certain estimates and assumptions regarding anticipatedperformance of the financing contracts sold, such as credit risk, prepayments,and discount rates. Management bases its estimates and assumptions onhistorical portfolio performance. There is no guarantee that historicalfinancing contract portfolio performance will be indicative of futureperformance.

 

*RevenueRecognition*- The Companyfinances equipment only after a customer’s credit has been approved and a leaseor financing agreement for the transaction has been executed. 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. TheCompany also capitalizes initial direct costs that relate to the origination ofleases and notes. These initial direct costs comprise certain specificactivities related to processing requests for financing, such as the costs tounderwrite the transaction, to prepare and execute the documentation, filingfees, and commission payments. Unearned income and deferred origination costsare amortized using the effective interest method over the life of thereceivable using the effective interest method.  Recognition of revenue and deferred origination costs aresuspended when a transaction enters the legal collection phase. The Companyalso recognizes revenues from fees from various portfolio service charges,gains and losses on prepayments, and miscellaneous assessments. Notesreceivable are reported at their outstanding principal balances. Interestincome on notes receivable and miscellaneous fees and assessments arerecognized on an accrual basis.

 

*DerivativeInstruments*-  In thenormal course of its business, the Company is subject to a variety of risks,including market risk associated with interest rate movements.  The Company is exposed to such interest raterisk from the time elapsed between the approval of a transaction with acustomer and when permanent fixed rate financing is secured. The Companymanages its exposure to interest rate risk by entering into interest rate swapagreements under its securitization transactions.  These amortizing swap agreements have the effect of convertingthe Company’s debt from securitizations from a variable rate to a fixed rate,thereby locking in financing spreads on its fixed rate lease and loanportfolio. All derivative instruments currently held by the Company aredesignated as hedges of interest risks pursuant to SFAS No. 133. Pursuant tothe hedge accounting requirements of SFAS No. 133, the fair value of the swapshedging on-balance sheet debt obligations is recorded as an asset or aliability on the balance sheet, with an offsetting unrealized gain or lossrecorded to Accumulated Other Comprehensive Income (Loss), net of tax, in stockholdersequity. In addition, the Company hasassigned portions of interest rate swap contracts to third parties inconnection with sales of leases and notes receivable. The net fair valueof the swap contracts hedging off-balance sheet transactions is not

 

28

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recorded on the Company’sbalance sheet. The Company may be subjected to realized gains or losses in theevent any of these amortizing interest rate swap contracts are terminatedprematurely.

 

**RESULTSOF OPERATIONS**

 

#### ***Fiscal Years Ended December 31, 2002 and December 31,2001***

 

The Company’s owned net investment in leases and notesincreased by 15% to $458,034,000 at December 31, 2002 from $396,996,000 atDecember 31, 2001.  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 $755,665,000 atDecember 31, 2002 from $648,406,000 at December 31, 2001, an increase of 17%.

 

Earned income from leases and notes for 2002 was$50,954,000 as compared to $47,970,000 for 2001. The 6% increase****wasprimarily due to an increase in the Company’s financing contract originationsin its core licensed professional financing segment. Total financing contractoriginations for fiscal 2002 increased approximately 18% to $310,607,000 from$263,411,000 for 2001. This was offset by an increase in asset sales activityduring 2002 as compared to 2001. Additionally, weighted-average implicit rates on the owned portfolio offinancing contracts decreased from 11.7% at December 31, 2001 to 11.2% atDecember 31, 2002. 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 netgains from sales of leases and notes increased to $15,804,000 in 2002 comparedto $14,928,000 in 2001, an increase of 6%. The $876,000 increase in gains onsales of assets in 2002 were due to higher levels of lease and loan contracts soldduring the current year in the licensed professional financing segment, whichcontributed $1,793,000 inadditional gain, offset by a decrease in market returns on such securitizationsin the current year, which reduced year over year gains by $174,000, and by a loss of $743,000from the sale of five loans in the commercial and industrial asset-basedfinancing segment.  For the twelvemonths ended December 31, 2002, the Company sold a portion of its beneficialinterest in leases and notes in its licensed professional financing segmenttotaling $163,328,000 comparedto $145,811,000 for the same period in 2001. In addition, the five revolving loans sold in thecommercial and industrial financing segment had a net book value of $7,426,000.The Company received proceeds of $6,683,000, plus accrued and unpaid interestto the date of sale, and incurred a pre-tax loss of $743,000.

 

Interest expense, net of interest income on cashbalances, was $25,345,000 (49.7% of earned income) in 2002, a 2% decrease fromthe comparable total of $25,993,000 (54.2% of earned income) for 2001.  The decrease in amount and percentage waslargely due to higher interest charges in 2001 associated with the $95,000,000provided to the Company from the ER 2000-1 prefunding arrangement as well as alower weighted-average cost of funds in 2002. Based on average outstanding borrowings, the Company’s cost of funds,including its Senior Subordinated Notes, was 5.7% and 6.5% at December 31, 2002 and 2001, respectively.

 

Net financing margin (earned income less net interestexpense) for fiscal year 2002 was $25,609,000 (50.3% of earned income) ascompared to $21,977,000 (45.8% of earned income) for 2001, a 16% increase.  The increase in amount and percentage waslargely due to the decline in net interest charges in 2002 from higher interestcharges incurred in the first quarter of 2001 associated with the $95,000,000provided to the Company from the ER 2000-1 prefunding arrangement as well as alower weighted average cost of funds in 2002 compared to 2001.

 

The provision for losses for the year ended December31, 2002 was $11,448,000 compared to $9,409,000 for the same period in 2001, a22% increase. The increase resulted in part from higher levels of newfinancings in 2002. In addition, the Company has experienced higher charge-offsin its portfolio of financing contracts. In reviewing these facts as well asthe potential impact of general economic conditions, the Company has increasedits allowance for losses. Duringthe third quarter of 2002, the Company’s asset-based lending subsidiary alsorecognized a loss of $1.3 million upon the final liquidation of inventory heldas collateral from a past due loan. This amount is included in both theprovision for losses and in net charge-offs against the allowance for lossesfor the period. At December 31, 2002, the Company’s allowance for losses was$16,900,000 compared to $15,539,000 at December 31, 2001. Total consolidatednet charge-offs for 2002 were **$**9,907,000compared to $8,220,000 in the prior year. The increase in 2002 was partiallydue to the $1.3 million charge-off in the Company’s asset-based lendingsubsidiary (described above). This variance was offset by a charge-off in 2001in the Company’s core financing segment from the bankruptcy of an equipmentvendor and resulting customer disputes over the products which the Company hadfinanced.  During the second quarter of2001, the Company agreed to settle the related lawsuit and subsequentlywrote-off approximately $1.8 million remaining due on the disputed customeraccounts.

 

Selling, general and administrative expenses forfiscal year 2002 increased 0.7% to $22,280,000 compared to $22,126,000

 

29

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for 2001. The increase was partially due to higher advertising andmarketing expenses, increased bank service charges and liquidity fees, andhigher payroll and related expenses.  Inaddition, legal and accounting related fees were higher in 2002 as a result ofthe employee defalcation described in the Company’s quarterly filing on Form10-Q for the period ended June 30, 2002. The Company has filed a claim with its fidelity insurance provider. Theclaim, in the amount of $1 million, has been denied by the insurance provider.  The Company is pursuing its legal remediesfor collection under the policy. The increases, as described above, werepartially offset by lower collection related expenses in 2002 than incurred in2001 when the Company experienced extraordinary expenses relating to thebankruptcy of an equipment vendor and settlement of a lawsuit against theCompany relating to the vendor’s products which the Company had financed.

 

During 2002, the Companydiscovered an employee defalcation resulting in pre-tax losses in 2002, 2001and 2000 of $448,000, $1,379,000 and $1,361,000, respectively.  The Company restated its prior yearfinancial statements to reflect these losses in the periods in which theyoccurred.

 

Income before income taxes for fiscal year 2002 was$7,237,000 compared to $3,991,000 for 2001, an 81% increase. The Company’seffective income tax rate for the year ended December 31, 2002 was 39.9%compared to 40.4% for the year 2001.  Net income for the year ended December31, 2002 was $4,346,000 ($1.00 diluted net income per share) compared to $2,379,000($0.55 diluted net income per share) for fiscal year 2001. The increase in netincome in 2002 compared to 2001 was due to an increase in earned income fromleases and notes, an increase in gains on sales of leases, and lower interestexpense.  These were offset by a higherprovision for losses in the current year compared to the prior year.

 

Net profit contribution, representing income beforeinterest and taxes, from the licensed professional financing segment was$34,946,000 for the year ended December 31, 2002 compared to $29,657,000 for the comparable period in2001, an 18% increase.** **The increase was due in part toan increase in earned income from leases and notes of $48,300,000 in 2002 from$44,047,000 in 2001, increased gains on sales of leases and notes of $16,547,000 in 2002 from $14,928,000in 2001 resulting from higher levels of lease and loan contracts sold offset bya decrease in market returns on securitizations in 2002 and offset by a higherprovision for losses in 2002 of $9,653,000 compared to $8,799,000 in 2001.

 

Net****profitcontribution (income (loss) before interest and taxes) from the commercial andindustrial asset-based financing segment was a loss of $2,364,000 for the yearended December 31, 2002 compared to gain of $327,000 for the comparable periodin 2001, an 623% decrease.****Thedecrease was caused by reduced earnings from a lower level of portfolio assetsof $2,654,000 in 2002 compared to $3,923,000 in 2001, as well as a higherprovision for losses of $1,795,000 in the current year compared to $610,000 inthe prior year.  In addition, selling,general and administrative expenses were $2,032,000 in 2002 compared to$1,607,000 in 2001, largely due to the costs incurred as a result of theemployee defalcation.  Lastly, the commercialand industrial asset-based financing segment sold five revolving loans in the current year and incurred a pre-tax lossof $743,000. These varianceswere partially offset a loss from the employee defalcation of $1,379,000 in the prior year compared to $448,000 in thecurrent year.

 

At December 31, 2002 theCompany had $163,000,000 of customer applications approved but which had notyet resulted in a completed financing transaction, compared to $119,000,000 ofsuch customer applications at December 31, 2001.  Not all approved applications will result in a completedfinancing transaction with the Company.

 

#### ***Fiscal Years Ended December 31, 2001 and December 31,2000***

 

The Company’s owned net investment in leases and notesincreased by 8% to $396,996,000 at December 31, 2001 from $368,169,000 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 $648,406,000 at December 31, 2001 from $556,895,000 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.

 

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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.

 

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 losses was$15,359,000 compared to $14,170,000 at December 31, 2000.  Total consolidated net charge-offs were$8,220,000 in 2001 compared to $4,198,000 in 2000.  The increase in 2001 was due in part to the bankruptcy of anequipment vendor and the resulting customer lawsuits over the vendor’s productsfinanced by the Company. The Company agreed to settle the related lawsuit inJune 2001 and subsequently charged-off approximately $1,800,000 representingthe 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 resultswere negatively affected by one-time charges of $7,106,000 associated withcompleting the $527,000,000 term securitization 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 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.

 

The Company recorded a pre-tax loss from an employeedefalcation of $1,379,000 and $1,361,000 for the twelve months ended December31, 2001 and 2000, respectively.

 

Income before income taxes for fiscal year 2001 was$3,991,000 compared to a pre-tax loss of $1,130,000 for 2000. The Company’seffective income tax rate for the year ended December 31, 2001 was 40.4%compared to 34.5% for the year 2000.  Net income for the year ended December31, 2001 was $2,379,000 ($0.55 diluted net income per share) compared to a lossof $739,000 ($0.19 diluted net loss per share) for fiscal year 2000. Theincrease in net income in 2001 compared to 2000 was due, in part, to anincrease in gains on sales of leases and notes and as a result of the one-timecharges incurred in 2000 in connection with the completion of the ER 2000-1term securitization. These were partially offset by slightly lower earnedincome on leases and notes and increased selling, general, and administrativecosts in 2001 as compared to the prior 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.  Theincrease was due in part from increased gains on sales of leases and notes of$14,928,000 in 2001 from $12,078,000 in 2000 resulting from higher levels oflease and loan contracts sold during the current year as well as improvedmarket conditions

 

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for 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.

 

Net profit contribution (income before interest andtaxes) from the commercial and industrial asset-based financing segment was$327,000 for the year ended December 31, 2001 compared to $1,430,000 for thecomparable period in 2000, a 77% 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.

 

**LIQUIDITYAND 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.  At December 31, 2002, the Company had access to credit under itsFoothill Revolver, the ER 2000-1 term securitization, its Bravo revolving securitizationfacility, its senior notes to savings banks, and its outstanding SeniorSubordinated Notes.  The Company alsoobtains cash from sales of its financing contracts under its securitizationfacilities and through collections generated from its lease and note portfolio.Substantially all of the assets of the Company have been pledged to HPSC’slenders as security under its various credit arrangements. The pledged assetsinclude all of the Company’s rights to receive payments under its financingcontracts and the collateral security granted to the Company by the borrowersunder those financing contracts. Borrowings under the Foothill Revolver andborrowings under senior notes to savings banks are full recourse obligations ofthe Company.

 

The Company’s financing strategy is to warehousetemporarily new financing contracts through borrowings under its FoothillRevolver. The warehouse borrowings are repaid with the proceeds obtained fromother permanent financings through the Company’s securitization facilities aswell as from cash flows generated from the financing contracts. The Companyusually obtains financing from its securitization facilities within 30 to 60days of original contract activation. Securitization financing may be in the form of a loan to the Company orin the form of a sale in which the value of the financing contract, except fora retained interest and the residual value, is removed from the Company’sbalance sheet. The Company is typically obligated to provide additional creditenhancement to credit providers.  Creditenhancement may be provided in various forms, including a retained interest inthe assets sold, the establishment of restricted cash reserve accounts, orthrough third-party financial guarantees. ACFC’s asset-based notes receivablehave been financed through borrowings under under the ACFC Foothill Revolverand through borrowings under the ER 2000-1 term securitization.

 

**Cash andCash Flow Activities**

At December 31, 2002, the Company had a total of $29,684,000 in cash, cash equivalentsand restricted cash as compared to $29,484,000 at the end of 2001.Substantially all of this cash was restricted pursuant to varioussecuritization agreements.  Componentsof restricted cash at December 31, 2002 and 2001 were as follows:

 
| **(in thousands)**                                |   | **2002** |   | **2001** |   |
|---------------------------------------------------|--------|----------|--------|----------|--------|
|                                              |   |     |   |     |   |
| Cash collections- Bravo                           |   | $        | 11,504 |     | $      | 4,358 |   |
| Cash escrow - Bravo swap agreements               |   | 264      |   | —   |   |
| Cash collections - ER 2000-1 LLC I                |   | 4,351    |   | 3,386    |   |
| Cash collections - ER 2000-1 LLC II               |   | 4,322    |   | 8,418    |   |
| Cash escrow - ER 2000-1 swap agreement            |   | 1,000    |   | 1,000    |   |
| Cash reserves - ER 2000-1                         |   | 7,349    |   | 11,624   |   |
| Cash collections - Foothill                       |   | 435      |   | —   |   |
| Cash due purchaser of asset-based loans from ACFC |   | 408      |   | —   |   |
| Total                                             |   | $        | 29,633 |     | $      | 28,786 |   |

 

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Cash and cash equivalents were $51,000 at December 31, 2002 comparedto $698,000 at December 31, 2001.  Thefollowing is a description of the significant activities affecting theCompany’s cash and cash equivalents for the years 2002 and 2001.

 

Cash provided by operating activities for the yearended December 31, 2002 was $13,698,000 compared to $5,965,000 for the prioryear. The significant changes in cash provided by operating activities were netincome of $4,346,000 in 2002 compared to $2,379,000 in 2001, adjusted forincreased non-cash gains on sales of leases and notes receivable of $15,804,000in 2002 compared to $14,928,000 in 2001, increased deferred income taxes in2002 of $2,790,000 compared to $1,525,000 in 2001, higher provision for creditlosses of $11,448,000 in 2002 compared to $9,409,000 in the prior year, and anincrease in accounts payable and accrued liabilities of $4,258,000 compared to$760,000 in the prior year.

 

Cash used in investingactivities was $181,719,000 for the year ended December 31, 2002 compared to$151,487,000 for the prior year. The significant components of cash used ininvesting activities were an increase in cash used to originate new leases andnotes receivables of $319,708,000 in 2002 compared to $258,782,000 in 2001,offset by portfolio receipts of $74,537,000 in 2002 and $79,115,000 in 2001, aswell as proceeds from sales of leases and notes receivable of $51,538,000 inthe current year as contrasted to $26,145,000 for the comparable 2001 period.

 

Cash provided by financing activities was $167,374,000for the year ended December 31, 2002 compared to $146,220,000 for the sameperiod in 2001. The major components of cash provided by financing activitiesinclude proceeds from the issuance of commercial paper conduit senior notes of$269,212,000 in 2002 as contrasted to $153,608,000 in 2001. During 2002, theCompany did not issue any new term securitization notes.  In 2001, the Company received net proceedsof $4,592,000 from the sale of the Class E and Class F ER 2000-1 termsecuritization notes. The proceeds received from the term securitization noteswere used to retire amounts outstanding under both the Company’s commercialpaper conduit facilities and warehouse revolving credit borrowings. Repaymentsof commercial paper conduit senior notes were $42,399,000 in 2002 compared to$51,209,000 in 2001. Repayments of term securitization notes were $47,066,000in the current year compared to $49,279,000 in the prior year. The Company hadnet repayments on revolving notes payable of $8,563,000 in 2002 compared to netborrowings of $3,000,000 in 2001. During 2002, the Company also began makingprincipal repayments on its subordinated notes, during which time $2,025,000 inprincipal was repaid as compared to none in the prior year.  In addition, restricted cash increased$847,000 during fiscal year 2002 as compared to a decrease of $86,299,000 in2001.  The decrease in 2001 resultedfrom the utilization of restricted cash provided to the Company through the ER2000-1 term securitization prefunding arrangement.

 

### **Warehouse Financing**

*RevolvingLoan Agreement*_ In May2001, the Company renewed and amended its revolving credit facility withFleet National Bank (the “Fleet Revolver”),providing availability to the Company of up to $83,500,000 through May 2002. InMay 2002, the Fleet Revolver was again renewed, providing availability of up to$75,000,000 through August 2002. Under the Fleet Revolver, a baseportion of the outstanding borrowings were at variable rates of 75 to 125 basispoints above the prime lending rate, while the remainder were at 225 to 275basis points above LIBOR rates. The level of spread to be paid above the baserate and LIBOR rates was dependent upon the Company’s balance sheet leverage aswell as compliance with certain performance covenants. At December 31, 2001,the Company had $52,000,000 outstanding under the Fleet Revolver.

 

In August 2002, Fleet National Bank assigned the FleetRevolver to Foothill Capital Corporation, as Agent. The Company contemporaneouslyexecuted an agreement with Foothill Capital Corporation and a group of lenders(the “Foothill Revolver”).  The FoothillRevolver provides for a line of credit to HPSC (the “HPSC Foothill Revolver”)and a separate line of credit to ACFC (the “ACFC Foothill Revolver”).  Under the terms of the HPSC FoothillRevolver, the Company may borrow up to $50,000,000 at variable interest ratesof prime plus .50% to 1.00% and at LIBOR plus 2.50% to 3.00%, depending upon theCompany’s balance sheet leverage.  The HPSCFoothill Revolver expires in August 2005. Under the ACFC Foothill Revolver,ACFC was permitted to borrow up to $20,000,000 at a variable interest rate ofprime plus 1.00% for the first 180 days and prime plus 2.00% thereafter.  The ACFC Foothill Revolver expired and waspaid in full on February 5, 2003. The HPSC Foothill Revolver is subject tocertain financial covenant requirements including, among others, tangible networth, leverage, and profitability levels. As of December 31, 2002, HPSCwas in compliance with its covenant requirements. Initial proceeds fromthe Foothill Revolver were used to repay remaining amounts due to FleetNational Bank under the Fleet Revolver. At December 31, 2002, the Company had $42,606,000 outstanding under the HPSC Foothill Revolver.  As discussed in the section entitled“Results of Operations”, on December 31, 2002 the Company sold five ACFC loansand received net proceeds of $6,683,000,which were used to repay amounts outstanding under the ACFC Foothill Revolver.At December 31, 2002 the Company had $831,000 remaining outstanding under theACFC Foothill Revolver. Borrowings under the Foothill Revolver are not hedged,and therefore, may be exposed to upward movements in interest rates.

 

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In November 2002, the HPSCFoothill Revolver was temporarily increased to $60,000,000 through January 24,2003.  On January 31, 2003, theHPSC Foothill Revolver was further amended to temporarily increase availabilityfrom $50,000,000 to $60,000,000, through April 24, 2003.  The January 31, 2003 amendment also permitsthe Company to borrow up to $750,000 in the HPSC Foothill Revolver to financethe operations of its ACFC subsidiary. On February 5, 2003, the Company borrowed $276,000 under the HPSCFoothill Revolver for the purpose of paying off the remaining outstandingbalance of the ACFC Foothill Revolver. The Company intends to seek permanentavailability above $50,000,000 under the Foothill Revolver, but there can be noassurance it will be able to do so.  Ifthe Company cannot obtain commitments above $50,000,000, the Company’s abilityto continue its historical growth rates may be constrained.

 

### **Permanent Financing**

*BravoFacility*_  In March2000, the Company, along with its wholly-owned, special-purpose subsidiary,HPSC Bravo Funding Inc. (later merged into HPSC Bravo Funding LLC) (“Bravo”),signed an amended revolving credit facility (the “Bravo Facility”)structured and guaranteed by MBIA, Inc. At December 31, 2002 and December 31, 2001, the Bravo Facility providedthe Company with available borrowings up to $450,000,000 and $385,000,000,respectively. Under the terms of the Bravo Facility, the Company contributescertain of its financing contracts to Bravo which, in turn, either pledges orsells its interests in these contracts to a commercial paper conduit entitywhich issues notes to investors. Credit enhancement is provided to thenoteholders through financial guarantees provided by MBIA as to the payment ofprincipal and interest on the notes. The Company’s current financing strategy is to either pledge or selleligible financing contracts to Bravo on a monthly basis, thereby minimizingits exposure to fluctuating interest rates in the Foothill Revolver warehousefacility.  Financing contracts pledgedby Bravo, along with the associated debt to the conduit entity, are included onthe Company’s consolidated balance sheet. In the case of financing contracts sold by Bravo, the contracts andassociated debt are removed from the Company’s consolidated balance sheet.Additional credit enhancement is provided to investors through the creation ofa retained interest in the financing contracts sold. Risk of loss to the Company is limited to the extent of the Company’s retained interest and residual values inthe financing contracts sold. Bravo incurs interest at variablerates in the commercial paper market and enters into interest rate swapcontracts to assure fixed-rate funding. Monthly settlements of principal and interest payments on the notes aremade from the collections on the Bravo financing contract portfolio.

 

The Company is the servicer of the Bravo portfolio,subject to its meeting certain performance covenants.  In August 2002, the covenant requirements of the Bravo Facilitywere amended to match substantially the covenant requirements of the HPSCFoothill Revolver.  The agreement waseffective for the quarter ended June 30, 2002. For each quarter prior to that date, a waiver had been obtained for the Company’s non-compliance with these covenantrequirements.  This non-complianceresulted primarily from costs incurred by the Company in connection withcompleting the ER 2000-1 asset securitization in December 2000 and the impactof the Company’s adoption of Statement of Financial Accounting Standard(“SFAS”) No. 133.  At December 31, 2002, the Company was incompliance with its amended covenant requirements in the Bravo Facility.  Under the terms of the Company’s other debtagreements, a default under the Bravo Facility could result in a cross defaultwhere the Company would also be in default with its other debt agreements. Ifsuch a cross default were to occur, it could significantly affect the Company’sability to continue to raise additional liquidity, which would likely result ina substantial curtailment of the Company’s current growth and operations. Inaddition, under such circumstances, the Company could be replaced as theservicer of the Bravo facility.

 

The Company executed a financingagreement with ING Capital LLC (“ING”) in August 2002 which provides additionalliquidity under the Bravo Facility. Under the terms of the agreement (the “ING portion of the BravoFacility”), ING will provide the Company with additional liquidity of up to3.75% of financing contracts held in the MBIA portion of the Bravo Facility, upto a maximum amount of $20,000,000. Interest on ING borrowings is payable on one-month LIBOR rates plus3%.  Amounts due under the ING portionof the Bravo Facility are subordinate to amounts due to the other lenders underthe Bravo Facility. to the ING portion of the Bravo Facility containsdelinquency and default covenant requirements that are more restrictive thanthose contained in the Bravo Facility. The ING portion of the Bravo Facility and the MBIA portion of the BravoFacility contain cross default provisions. At December 31, 2002, theCompany was in compliance with its covenant requirements in the ING portion ofthe Bravo Facility.  Initialproceeds of $13,840,000 from the ING portion of the Bravo Facility were used toretire amounts outstanding under the Fleet Revolver.

 

At December 31, 2002, the Company had total debt of $220,934,000 outstanding under the loanportion of the Bravo Facility and, in connection therewith, had interest rateswap contracts outstanding with a total notional value of $208,202,000. Thetotal amount outstanding under the sales portion of the Bravo Facility was $213,624,000 at December 31, 2002and, in connection therewith, the Company had outstanding interest rate swap contractsassigned to third parties with a notional value of $208,245,000.

 

On January 29, 2003, the MBIA portion of the BravoFacility was amended to temporarily increase availability to the Company from$450,000,000 to $525,000,000.  Theincreased liquidity expires upon the earlier to occur of either the completionby the Company of a new term securitization transaction (see Gloucester Funding2003-1 described below) or April 30, 2003. In addition, continued availability to the Company

 

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under the Bravo Facility is contingent upon the Company’s obtaining anadditional securitization conduit facility with a third party (similar innature to the Bravo Facility).  Theamendment requires that the new conduit facility must be arranged by June 23,2003 and must provide the Company with a line of availability of at least$150,000,000.

 

The MBIA and ING portions of the Bravo Facility expirein June 2003.  The Company intends tocontinue to utilize the Bravo Facility for a portion of its permanent financingrequirements. The Company expects that it will be able to renew the BravoFacility.  It is possible, however, thatthe Bravo Facility or the banks providing liquidity under the facility will notextend their commitment.  In addition,although the Company believes that it can arrange a new conduit facility with athird party by June 2003, there can be no assurance it will be able to doso.  If the Bravo Facility is notrenewed, the Facility may then be limited to the then existing outstandings andmay not be available to the Company to provide future liquidity.  If the liquidity banks terminate or reducetheir commitment, the Company will seek to replace the terminated or reducedamount, but there can be no assurance that the Company will be able to doso.   If the Bravo Facility isunavailable, the Company may be unable to conduct its business or may be unableto conduct its business at current levels.

 

*EquipmentReceivables 2000-1*_ In December 2000, the Company completed a $527,106,000 private placementterm securitization, referred to as 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 is limited to the extent of the Company’s retained interest and residual values inthe financing contracts sold. Financing contracts transferred to ER 2000-1 LLC II were pledged ascollateral on the notes, with the carrying value of the financing contracts andassociated debt included in the Company’s consolidated balance sheet. Theproceeds from the notes were used to retire senior notes and other obligationsoutstanding in both the Bravo and Capital Facilities as well as to pay downamounts outstanding under the Fleet Revolver warehouse 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 wasused to prepay principal on the notes.TheER 2000-1 securitization agreement also provided for $1,049,000 of initialproceeds to be placed in a restricted cash account to service interestrequirements to the noteholders on the prefunded debt outstanding during theprefunding period.  In addition, initialproceeds of $2,735,000 were deposited in the restricted cash collection accountto service the interest requirements on the ER 2000-1 notes for the initialinterest 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 of financing contracts are deposited to the cashreserve account or residual payment account, up to agreed-upon limits. Theserestricted cash accounts are available to fund monthly interest and principalpayments on the ER 2000-1 notes in the event of deficiencies from the monthlycollections.  At December 31, 2002 and2001, the balance in these restricted cash reserve accounts was $7,349,000 and $11,624,000,respectively. The Company may also provide additional credit enhancementthrough the substitution of new leases and notes for leases and notespreviously transferred 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, 2002, ER 2000-1 LLC I had a total of $128,964,000 outstanding related to sales of financing contractsand, in connection with the amounts financed through the issuance of the ClassA and Class B-1 variable-rate notes, had interest rate swap contracts assignedto third parties with a total notional value of $115,287,000. At December 31, 2002, ER 2000-1 LLC II had total debtoutstanding, net of unamortized original issue discount, with a remainingprincipal balance of $100,145,000and, in connection with the amounts financed through the issuance of the ClassA and Class B-1 variable-rate notes, had interest rate swap contractsoutstanding with a total notional value of $90,033,000.

 

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.

 

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Under certain circumstances, the Company may be obligated to advanceits own funds for amounts due on the notes in the event an obligor fails toremit a payment when due. The Company is reimbursed for such advances fromavailable funds upon the subsequent collection from the obligor. Creditenhancement is provided through the structuring of several classes of notes,which are ranked for purposes of determining priority of payment. Under theterms of the various debt agreements, an event of default for non-compliance bythe Company with its covenants may result in an immediate acceleration of allprincipal amounts outstanding under all classes of notes. If such an event ofdefault were to occur, the Company’s ability to continue to raise additionalliquidity could be adversely affected, which would likely result in asubstantial curtailment of the Company’s current growth and operations. Inaddition, the Company could be replaced as the servicer of the portfolio.

 

*Various Banks_*****The Company periodically enters into secured,fixed-rate, fixed-term loan agreements with various banks for purposes offinancing its operations. The loans are generally subject to certain recourseand performance covenants. At December 31, 2002, the Company had outstandingborrowings under such loan agreements of approximately $7,211,000 with annual interest ratesranging from 6.5% to 8.0%. These loans, which are fullrecourse to the Company, are included on the Company’s consolidated balancesheet as senior notes.

 

*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 theFleet Revolver.  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 began redeeming, throughsinking-fund payments, a portion of the aggregate principal amount of theSenior Subordinated Notes at a quarterly redemption price of $1,000,000 plusaccrued but unpaid interest to the redemption date.  Such payments are required January 1, April 1, July 1, andOctober 1 of each year until maturity. The Company expects to be able to meet its payment obligations under itsSenior Subordinated Notes, but there can be no assurance that it will be able todo so.  The Senior Subordinated Notes arefull recourse to the Company.

 

*Gloucester Funding 2003-1*_On March 31, 2003, the Company completed a $323,190,000 private placement termsecuritization.  In conjunction with thesecuritization, the Company created two new special-purpose entities, HPSC Gloucester Funding 2003-1 LLC I (GF 2003-1LLC I) and HPSC Gloucester Funding 2003-1 LLC II (GF 2003-1 LLC II). Theseentities were formed to issue notes to finance the purchase of, and loanagainst, leases and notes transferred from HPSC and Bravo.  GF 2003-1 LLC I was formed to meet thecriteria of a qualifying unconsolidated special-purpose entity within themeaning of SFAS No. 140, while GF 2003-1 LLC II was formed to be a consolidatedspecial-purpose entity.  The initialfinancing contracts contributed to the securitization were transferred by HPSCand Bravo to GF 2003-1 LLC II. Financing contracts transferred to GF2003-1 LLC II were pledged as collateral for the notes, with the carrying valueof the financing contracts and associated debt included in the Company’sconsolidated balance sheet.  Proceeds from the note offering were used topay down amounts outstanding in both the MBIA and ING portions of the BravoFacility.  In addition, approximately15% of the total proceeds from the notes were set aside in a restrictedprefunding account for the purpose of acquiring future financing contracts fromthe Company.

 

The Company plans periodically to enter into andutilize term securitizations in the future to finance portions of its financingcontracts. The timing and the ability of theCompany to complete such financings will depend, to a large extent, on marketconditions for such transactions, and there can be no assurance that theCompany will be able to enter into such securitizations or that it will be ableto do so in a timely fashion.

 

### **Off-balance sheet arrangements**

Asdiscussed above, the Company routinely sells leases and notes pursuant tosecuritization agreements.  The salestransactions are accomplished by first transferring the financing contracts toa bankruptcy remote, non-consolidated special-purpose entity, which, in turn,sells its interest in those contracts. The Company surrenders control over the financing contracts transferredto the qualifying special purpose entity. In all such sales transactions todate, the Company has provided additional credit enhancement to the noteholdersthrough the establishment of a retained interest in the financing contractssold. The Company’s primary exposure in determining the fair value of itsretained interest in securitized financing contracts is credit risk associatedwith the obligors on these contracts. The Company’s retained interest in itsfinancing contracts is subordinate to the interests of its credit providers.  In recording the net gain upon the sale offinancing contracts and the fair value of its retained interest, the Companyassumes a loss rate of approximately 0.50% per annum on a static pool basis,and discounts its retained interest at implicit rates ranging from 10.6% to 14.8%.  Prepayment risk onsecuritized financing contracts is limited due to the Company’s prepaymentpolicies with its obligors. To

 

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eliminate interest rate risk, theCompany enters into interest rate swap contracts as a hedge against itsvariable rate obligations.  The fairvalue of the retained interest in the financing contracts sold is reviewed forimpairment on a quarterly basis. The Company does not sell the residual valuesin its sold financing contracts which are lease agreements.  Riskof loss to the Company under its Bravo and ER 2000-1 sales agreements islimited to the extent of the Company’s retained interest and residual values inthe financing contracts sold to those facilities.  The Company maintains an allowance forlosses designed to cover potential exposures in both its owned on-balance sheetportfolio as well as its residual interests in sold off-balance sheetcontracts.  Historically, the Companyhas sold contracts through its securitization facilities each quarter.For the twelve months ended December 31, 2002, the Company sold a portion ofits beneficial interest in leases and notes totaling $163,328,000 compared to $145,811,000 for the same period in2001.  For the same periods, the Companyrecognized pre-tax gains from sales of financing contracts of $16,547,000 and$14,928,000, respectively, which is included in “Gain on sales of leases andnotes, net” on the Company’s Consolidated Statement of Operations.

 

### **Summaryof total contractual obligations**

A summary of the Company’s totaldebt obligations, the total on-and-off-balance sheet financing contractsoutstanding through the Company’s various securitization facilities, and futureminimum lease payments under its non-cancelable operating leases for its officelocations, is as follows at December 31, 2002:

 

| **(in thousands)**  |   | **On-Balance  Sheet Debt** |    | **Off-Balance  Sheet Sold  Financing  Contracts** |   | **Operating  Leases** |   | **Total** |   |
|---------------------|--------|----------------------------|---------|---------------------------------------------------|--------|-----------------------|--------|-----------|--------|
| 2003                |   | $                          | 100,909 |                                              | $      | 106,510               |   | $         | 777    |   | $ | 208,196 |   |
| 2004                |   | 79,431                     |    | 84,332                                            |   | 339                   |   | 164,102   |   |
| 2005                |   | 110,383                    |    | 65,008                                            |   | 34                    |   | 175,425   |   |
| 2006                |   | 53,708                     |    | 45,106                                            |   | —                |   | 98,814    |   |
| 2007                |   | 35,773                     |    | 27,169                                            |   | —                |   | 62,942    |   |
| 2008 and thereafter |   | 26,609                     |    | 14,463                                            |   | —                |   | 41,072    |   |
| Total               |   | $                          | 406,813 |                                              | $      | 342,588               |   | $         | 1,150  |   | $ | 750,551 |   |

 

### **Stock Repurchase Program**

In December 2000, the Boardof Directors approved an increase to the stock repurchase program whereby theCompany may repurchase up to an additional 250,000 shares of the Company’scommon stock subject to maximum dollar limitations set forth under the Company’sFoothill Revolver and Senior Subordinated Note financing. Based on currentmarket values at December 31, 2002 and the limitations set forth in its mostrestrictive debt agreement, the Company may repurchase up to an additional129,000 shares of its common stock. No time limit has been established for therepurchase program. The Company expects to use the repurchased stock to meetthe current and future requirements of its employee stock plans.  During 2002, the Company repurchased 70,186shares of its common stock for approximately $538,000.

 

Management believes that the Company’s sources ofliquidity, including the Foothill Revolver, the Bravo Facility, the ER 2000-1securitization, the Gloucester Funding2003-1 securitization, the Senior Subordinated Notes, and loans fromvarious savings banks, along with cash obtained from the sales of its financingcontracts and from internally generated revenues, are adequate to meet currentobligations and carry on current operations. In order to finance its future operations, the Company will seek torenew and/or obtain new liquidity facilities and may seek to raise additionalequity. The Company expects that it will be able to obtain additional capitalat competitive rates, but there can be no assurance it will be able to do so.

 

**QUANTITATIVEAND QUALITATIVE DISCLOSURES 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.

 

The Company temporarily finances its new fixed-ratefinancing contracts through a variable-rate revolving warehouse line of credituntil permanent 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 permanent financing within 60 days ofthe 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

 

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securitization notes. These swap agreements have the effect ofconverting the Company’s securitization debt from a variable-rate to afixed-rate. At December 31, 2002, the net marked-to-market value of interestrate swap contracts hedging on-balance sheet debt obligations was a liabilityof $9,406,000. Assuming ahypothetical 10% reduction in interest rates from current weighted-average swaprates at December 31, 2002, the marked-to-market valuation of these swapagreements would have been approximately $12,807,000.

 

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 theCompany’s fixed-rate assets and fixed-rate debt. In a rising interest rateenvironment, fixed-rate assets lose market value whereas fixed-rate liabilitiesgain market value. The opposite is true in a declining rate environment. Thefair value of fixed-rate financial assets and liabilities can be determined bydiscounting associated cashflows at market rates currently available forinstruments with similar risk characteristics and maturities. Sensitivityanalysis can be applied to determine the positive or negative effect marketrisk exposures may have on the fair value of the Company’s financial assets andliabilities. The following table summarizes the carrying value and estimatedfair value of the Company’s fixed-rate assets and liabilities at December 31,2002. The table also demonstrates the degree of sensitivity to the fair valueof the Company’s fixed-rate financial assets and liabilities assuming ahypothetical 10% adverse change from actual rates:

 
| **(in thousands)**                              |   | **Carrying  Value** |    | **Fair Value** |   | **10% change** |   |
|-------------------------------------------------|--------|---------------------|---------|----------------|--------|----------------|--------|
| Fixed-rate leases and notes due in installments |   | $                   | 392,405 |           | $      | 394,932        |   | $ | 383,767 |   |
| Fixed-rate debt                                 |   | 346,250             |    | 330,317        |   | 350,277        |   |
|                                                 |        |                     |         |                |        |                |        |  |  |  |

 

The Company’s variable-rate assets consist ofcommercial and industrial asset-based revolving loans originated by ACFC andprogress payment notes receivable originated by HPSC in the healthcarefinancing segment. The Company’s variable-rate liabilities consist of amountsoutstanding under the Foothill Revolver and senior notes outstanding under theING portion of the Bravo Facility. The carrying value of variable-rate assetsand liabilities approximates current fair values. Sensitivity analysis can beused to determine the positive or negative affect on the Company’s interestincome and interest expense due to changes in market interest rates, assummarized as follows at December 31, 2002:

 
| **(in thousands)**             |   | **Carrying  Value** |   | **Fair Value** |   | **+/-Change  to  interest assuming  +/-10% change  from actual rates** |   |
|--------------------------------|--------|---------------------|--------|----------------|--------|------------------------------------------------------------------------|--------|
| Variable-rate notes receivable |   | $                   | 21,052 |           | $      | 21,052                                                                 |   | $ | +/-302 |   |
| Variable-rate debt             |   | 60,014              |   | 60,014         |   | +/-195                                                                 |   |
|                                |        |                     |        |                |        |                                                                        |        |  |  |  |

 

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, including warehouse and permanent financing facilities;compliance with financial and other covenants in funding documents; paymentrestrictions and default risks in asset securitization transactions; the riskof being removed as the servicer of its securititzation facilities; customercredit risks; competition for customers and for capital funding at favorablerates relative to the capital costs of the Company’s competitors; changes inhealthcare payment policies; interest rate risk; the risk that the Company maynot be able to realize the residual value on financed equipment at the end of itslease term; interest rate swap contract risks; risks associated with the saleof certain receivable pools by the Company; dependence on sales representativesand the current management team; and fluctuations in quarterly operatingresults. The Company’s filings with the Securities and Exchange Commission,including its Annual Report on Form 10-K for the year ended December 31, 2002filed on March 31, 2003, contain additional information concerning such riskfactors.  Actual results in the futurecould differ materially from those described in the forward-looking statementsas a result of the risk factors set forth above, the risk factors described inthe Annual Report on Form 10-K, and the matters set forth in this Annual Reportgenerally.  HPSC cautions the reader,however, that such list of risk factors may not be exhaustive. HPSC undertakesno obligation to release publicly the result of any revisions to theseforward-looking statements that may be made to reflect any future events orcircumstances.

 

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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**         |   | **Raymond  R. Doherty (3)**                          |   | **COUNSEL**                                                                                                                                                                                                                                                                                                                                    |
| President                       |   | President                                            |   |                                                                                                                                                                                                                                                                                                                                           |
| Chief Operating Officer         |   | Chief Operating Officer                              |   | Day Berry & Howard LLP                                                                                                                                                                                                                                                                                                                     |
|                            |   |                                                 |   | 260 Franklin Street                                                                                                                                                                                                                                                                                                                            |
|                            |   | **J.  Kermit Birchfield, Jr. (1)(2)(3)(4)**          |   | Boston, Massachusetts  02110                                                                                                                                                                                                                                                                                                              |
| **Rene  Lefebvre**              |   | Chairman                                             |   |                                                                                                                                                                                                                                                                                                                                           |
| Senior Executive Vice President |   | Displaytech, Inc.                                    |   | **TRANSFER  AGENT**                                                                                                                                                                                                                                                                                                                            |
| Treasurer                       |   |                                                 |   |                                                                                                                                                                                                                                                                                                                                           |
| Chief Financial Officer         |   | **Dollie  Cole (1)**                                 |   | Equiserve Trust Company                                                                                                                                                                                                                                                                                                                        |
|                            |   | Chairperson                                          |   | P.O. Box 43010                                                                                                                                                                                                                                                                                                                                 |
|                            |   | Dollie Cole Corporation                              |   | Providence, RI. 02940-3068                                                                                                                                                                                                                                                                                                                     |
| **Stephen  K. Ballou**          |   |                                                 |   |                                                                                                                                                                                                                                                                                                                                           |
| Vice President- Operations      |   | **Samuel  P. Cooley (2)(3)(4)**                      |   | Shareholder Inquiries:                                                                                                                                                                                                                                                                                                                         |
|                            |   | Retired                                              |   | (781) 575-3400                                                                                                                                                                                                                                                                                                                                 |
|                            |   | Former Executive Vice President,                     |   | www.equiserve.com                                                                                                                                                                                                                                                                                                                              |
| **William  S. Hoft**            |   | Shawmut National Corp.                               |   |                                                                                                                                                                                                                                                                                                                                           |
| Vice President- Finance         |   |                                                 |   | **10-K**                                                                                                                                                                                                                                                                                                                                       |
|                            |   | **Richard  D. Field (1)(2)(4)**                      |   |                                                                                                                                                                                                                                                                                                                                           |
|                            |   | Private Investor                                     |   |                                                                                                                                                                                                                                                                                                                                           |
|                            |   | Former Senior Executive Vice President,              |   | HPSC’s Annual Report on Form                                                                                                                                                                                                                                                                                                              |
|                            |   | The Bank of New York                                 |   | 10-K is available to stockholders without charge by  writing to:                                                                                                                                                                                                                                                                               |
|                            |   |                                                 |   |                                                                                                                                                                                                                                                                                                                                           |
|                            |   | **Thomas  M. McDougal, DDS (4)**                     |   | Investor Relations Department                                                                                                                                                                                                                                                                                                                  |
|                            |   | Practicing Dentist                                   |   | HPSC, Inc.                                                                                                                                                                                                                                                                                                                                     |
|                            |   |                                                 |   | 60 State Street, Suite 3520                                                                                                                                                                                                                                                                                                                    |
|                            |   | **Lowell  P. Weicker, Jr. (1)(2)(4)**                |   | Boston, Massachusetts  02109                                                                                                                                                                                                                                                                                                              |
|                            |   | Former Governor and                                  |   |                                                                                                                                                                                                                                                                                                                                           |
|                            |   | U.S. Senator from Connecticut                        |   | E-mail address:                                                                                                                                                                                                                                                                                                                                |
|                            |   |                                                 |   | hpsc@hpsc.com                                                                                                                                                                                                                                                                                                                                  |
|                            |   |                                                 |   |                                                                                                                                                                                                                                                                                                                                           |
|                            |   |                                                 |   | Internet web site:                                                                                                                                                                                                                                                                                                                             |
|                            |   |                                                 |   | www.hpsc.com                                                                                                                                                                                                                                                                                                                                   |
|                            |   |                                                      |   |                                                                                                                                                                                                                                                                                                                                           |
|                            |   | *(1)  Member, Compensation  Committee*          |   | 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 |
|                            |   |                                                 |   |
|                            |   | *(2)  Member, Audit Committee*                  |   |
|                            |   |                                                 |   |
|                            |   | *(3)  Member, Executive Committee*              |   |
|                            |   |                                                 |   |
|                            |   | (4) * Member,  Corporate Governance  Committee* |   |

 

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