##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-QSB



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QUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For the Quarterly Period Ended September 30, 2004



Commission File Number: 000-28342



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VALLEY FINANCIAL CORPORATION



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|                         |  |                                        
|------------------------ |  | ---------------------------------------
|VIRGINIA                 |  | 54-1702380                             
|(State of Incorporation) |  | (I.R.S. Employer Identification Number)



36 Church Avenue,
S.W.

Roanoke, Virginia 24011

(Address of principal executive offices)



(540) 342-2265

(Issuers telephone number, including area code)



---



Check whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the small business
issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



At November 12, 2004 there were 3,799,630 shares of the issuers common stock, no par value, outstanding.



Transitional small business disclosure format:    Yes ̈No  x.



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##### Table of Contents

VALLEY FINANCIAL CORPORATION

FORM 10-QSB

September 30, 2004



INDEX



|                                                            |  |   
|----------------------------------------------------------- |  | --
|Part I. FINANCIAL INFORMATION                               |  |   
|                                                            | 
|Item 1.
Financial Statements                                |  |   
|                                                            | 
|Consolidated Balance Sheets                                 |  | 3 
|                                                            | 
|Consolidated Statements of Income                           |  | 4 
|                                                            | 
|Consolidated Statements of Cash Flows                       |  | 6 
|                                                            | 
|Notes to Consolidated Financial Statements                  |  | 8 
|                                                            | 
|Item 2.
Managements Discussion and Analysis                |  | 14
|                                                            | 
|Item 3.
Controls and Procedures                             |  | 26
|                                                            | 
|Part II. OTHER INFORMATION                                  |  |   
|                                                            | 
|Item 4.
Submission of Matters to a Vote of Security Holders |  | 27
|                                                            | 
|Item 5.
Other Information                                   |  | 28
|                                                            | 
|Item 6.
Exhibits and Reports on Form 8-K                    |  | 28
|                                                            | 
|SIGNATURES                                                  |  | 30
|                                                            | 
|EXHIBIT INDEX                                               |  | 31
|                                                            | 
|CERTIFICATIONS                                              |  | 33



2



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##### Table of Contents

PART 1  FINANCIAL INFORMATION

Item 1. Financial Statements.



VALLEY FINANCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)



|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|---------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------- | - | --------------- | - | ------- | -
|                                                                                                                                                     |  | (Unaudited) September 302004 |         |   | December 312003 |  
|Assets                                                                                                                                               |  |                              |         |   |                 |   |         |  
|Cash and due from banks                                                                                                                              |  | $                            | 7,012   |   |                 | $ | 7,511   |  
|Short term investments:                                                                                                                              |  |                              |         |   |                 |   |         |  
|Federal funds sold                                                                                                                                   |  |                              | 621     |   |                 |   |        |  
|Interest-bearing deposits in other banks                                                                                                             |  |                              | 345     |   |                 |   | 713     |  
|Securities held to maturity (approximate market values of $22,861 at September 30, 2004 and $22,828 at December 31, 2003)                            |  |                              | 22,749  |   |                 |   | 22,986  |  
|Securities available for sale                                                                                                                        |  |                              | 48,273  |   |                 |   | 40,066  |  
|Restricted equity securities                                                                                                                         |  |                              | 3,143   |   |                 |   | 3,143   |  
|Loans:                                                                                                                                               |  |                              |         |   |                 |   |         |  
|Commercial and industrial loans                                                                                                                      |  |                              | 68,239  |   |                 |   | 53,141  |  
|Commercial real estate loans                                                                                                                         |  |                              | 104,162 |   |                 |   | 92,563  |  
|Real estate construction                                                                                                                             |  |                              | 23,291  |   |                 |   | 17,622  |  
|Residential real estate loans                                                                                                                        |  |                              | 40,290  |   |                 |   | 29,959  |  
|Loans to individuals                                                                                                                                 |  |                              | 34,371  |   |                 |   | 29,318  |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Total loans                                                                                                                                          |  |                              | 270,353 |   |                 |   | 222,603 |  
|Less unearned income                                                                                                                                 |  |                              | (2      | ) |                 |   | (5      | )
|Less allowance for loan losses                                                                                                                       |  |                              | (3,023  | ) |                 |   | (2,566  | )
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Net loans                                                                                                                                            |  |                              | 267,328 |   |                 |   | 220,032 |  
|Premises and equipment                                                                                                                               |  |                              | 6,100   |   |                 |   | 6,067   |  
|Bank owned life insurance                                                                                                                            |  |                              | 6,061   |   |                 |   | 5,835   |  
|Accrued interest receivable                                                                                                                          |  |                              | 1,452   |   |                 |   | 1,204   |  
|Other assets                                                                                                                                         |  |                              | 1,577   |   |                 |   | 1,452   |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Total assets                                                                                                                                         |  | $                            | 364,661 |   |                 | $ | 309,009 |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Liabilities and Shareholders Equity                                                                                                                 |  |                              |         |   |                 |   |         |  
|Deposits:                                                                                                                                            |  |                              |         |   |                 |   |         |  
|Non-interest bearing demand deposits                                                                                                                 |  | $                            | 43,453  |   |                 | $ | 36,668  |  
|Interest bearing demand deposits                                                                                                                     |  |                              | 16,610  |   |                 |   | 16,602  |  
|Money market deposits                                                                                                                                |  |                              | 33,989  |   |                 |   | 29,217  |  
|Other savings deposits                                                                                                                               |  |                              | 4,936   |   |                 |   | 4,593   |  
|Certificates of deposits >$100,000                                                                                                                   |  |                              | 40,160  |   |                 |   | 39,464  |  
|Other time deposits                                                                                                                                  |  |                              | 138,018 |   |                 |   | 96,478  |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Total deposits                                                                                                                                       |  |                              | 277,166 |   |                 |   | 223,022 |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Short-term borrowings                                                                                                                                |  |                              | 15,000  |   |                 |   | 15,000  |  
|Federal funds purchased                                                                                                                              |  |                              |        |   |                 |   | 2,556   |  
|Securities sold under agreements to repurchase                                                                                                       |  |                              | 5,776   |   |                 |   | 4,727   |  
|Guaranteed preferred beneficial interests in the Companys junior subordinated debentures                                                            |  |                              | 4,000   |   |                 |   | 4,000   |  
|Long-term borrowings                                                                                                                                 |  |                              | 37,000  |   |                 |   | 37,000  |  
|Accrued interest payable                                                                                                                             |  |                              | 1,039   |   |                 |   | 736     |  
|Other liabilities                                                                                                                                    |  |                              | 586     |   |                 |   | 406     |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Total liabilities                                                                                                                                    |  |                              | 340,567 |   |                 |   | 287,447 |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Commitments and other contingencies                                                                                                                  |  |                              |         |   |                 |   |         |  
|                                                                                                                                                     |  |                             
|Preferred stock, no par value. Authorized 10,000,000 shares; none issued and outstanding.                                                            |  |                              |         |   |                 |   |         |  
|Common stock, no par value. Authorized 10,000,000 shares; issued and outstanding 3,799,630 at September 30, 2004 and 3,665,502 at December 31,
2003. |  |                              | 13,150  |   |                 |   | 12,396  |  
|Accumulated retained earnings                                                                                                                        |  |                              | 10,712  |   |                 |   | 8,969   |  
|Accumulated other comprehensive income                                                                                                               |  |                              | 232     |   |                 |   | 197     |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Total shareholders equity                                                                                                                           |  |                              | 24,094  |   |                 |   | 21,562  |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  
|Total liabilities and shareholders equity                                                                                                           |  | $                            | 364,661 |   |                 | $ | 309,009 |  
|                                                                                                                                                     |  |                              |         |   |                 |   |         |  



See accompanying notes to consolidated
financial statements.



3



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##### Table of Contents

VALLEY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except
per share data)



|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|----------------------------------------------------------------------------------------------------- |  | --------------------------------------------------------- | ------ | --------------------------------------------------------- | - | ------ | -
|                                                                                                      |  | For the Period January 1, 2004 Through September 30, 2004 |        | For the Period January 1, 2003 Through September 30, 2003 |  
|Interest Income:                                                                                      |  |                                                           |        |                                                           |   |        |  
|Interest and fees on loans                                                                            |  | $                                                         | 10,667 |                                                           | $ | 9,681  |  
|Interest on short term investments                                                                    |  |                                                           | 41     |                                                           |   | 47     |  
|Interest on securities  taxable                                                                      |  |                                                           | 1,675  |                                                           |   | 1,084  |  
|Interest on securities  nontaxable                                                                   |  |                                                           | 485    |                                                           |   | 465    |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Total interest income                                                                                 |  |                                                           | 12,868 |                                                           |   | 11,277 |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Interest Expense:                                                                                     |  |                                                           |        |                                                           |   |        |  
|Interest on certificates of deposit > $100,000                                                        |  |                                                           | 763    |                                                           |   | 727    |  
|Interest on other deposits                                                                            |  |                                                           | 2,716  |                                                           |   | 2,201  |  
|Interest on long-term borrowings                                                                      |  |                                                           | 1,183  |                                                           |   | 1,139  |  
|Interest on repurchase agreements                                                                     |  |                                                           | 32     |                                                           |   | 39     |  
|Interest on federal funds purchased                                                                   |  |                                                           | 20     |                                                           |   |       |  
|Interest on guaranteed preferred beneficial interests in the Companys junior subordinated debentures |  |                                                           | 134    |                                                           |   | 45     |  
|Interest on short-term borrowings                                                                     |  |                                                           | 155    |                                                           |   | 114    |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Total interest expense                                                                                |  |                                                           | 5,003  |                                                           |   | 4,265  |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Net interest income                                                                                   |  |                                                           | 7,865  |                                                           |   | 7,012  |  
|                                                                                                      |  |                                                          
|Provision for loan losses                                                                             |  |                                                           | 578    |                                                           |   | 471    |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Net interest income after provision for loan losses                                                   |  |                                                           | 7,287  |                                                           |   | 6,541  |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Noninterest income:                                                                                   |  |                                                           |        |                                                           |   |        |  
|Service charges on deposit accounts                                                                   |  |                                                           | 579    |                                                           |   | 534    |  
|Income earned on bank owned life insurance                                                            |  |                                                           | 226    |                                                           |   | 203    |  
|Other income on real estate loans                                                                     |  |                                                           | 74     |                                                           |   | 157    |  
|Other fee income                                                                                      |  |                                                           | 109    |                                                           |   | 118    |  
|Realized gains on sales of securities available for sale                                              |  |                                                           | 17     |                                                           |   | 7      |  
|Losses on foreclosed properties                                                                       |  |                                                           |       |                                                           |   | (9     | )
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Total noninterest income                                                                              |  |                                                           | 1,005  |                                                           |   | 1,010  |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Noninterest expense:                                                                                  |  |                                                           |        |                                                           |   |        |  
|Compensation expense                                                                                  |  |                                                           | 3,033  |                                                           |   | 2,684  |  
|Occupancy expense                                                                                     |  |                                                           | 363    |                                                           |   | 283    |  
|Data processing and equipment expense                                                                 |  |                                                           | 694    |                                                           |   | 541    |  
|Franchise tax expense                                                                                 |  |                                                           | 124    |                                                           |   |       |  
|Purchased tax credit expense                                                                          |  |                                                           | 25     |                                                           |   | 248    |  
|Deposit expenses                                                                                      |  |                                                           | 139    |                                                           |   | 115    |  
|Loan expenses                                                                                         |  |                                                           | 319    |                                                           |   | 254    |  
|Other expense                                                                                         |  |                                                           | 936    |                                                           |   | 785    |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Total noninterest expense                                                                             |  |                                                           | 5,633  |                                                           |   | 4,910  |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Net income before taxes                                                                               |  |                                                           | 2,659  |                                                           |   | 2,641  |  
|                                                                                                      |  |                                                          
|Provision for income taxes                                                                            |  |                                                           | 689    |                                                           |   | 598    |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Net income                                                                                            |  | $                                                         | 1,970  |                                                           | $ | 2,043  |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Basic earnings per share                                                                              |  | $                                                         | 0.53   |                                                           | $ | 0.56   |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  
|Diluted earnings per share                                                                            |  | $                                                         | 0.49   |                                                           | $ | 0.53   |  
|                                                                                                      |  |                                                           |        |                                                           |   |        |  



See accompanying notes to consolidated
financial statements.



4



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##### Table of Contents

VALLEY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

(In thousands, except per share data)



|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|----------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------ | ----- | ------------------------------------------------------ | - | ----- | -
|                                                                                                      |  | For the Period July 1, 2004 Through September 30, 2004 |       | For the Period July 1, 2003 Through September 30, 2003 |  
|Interest Income:                                                                                      |  |                                                        |       |                                                        |   |       |  
|Interest and fees on loans                                                                            |  | $                                                      | 3,822 |                                                        | $ | 3,307 |  
|Interest on short term investments                                                                    |  |                                                        | 15    |                                                        |   | 7     |  
|Interest on securities  taxable                                                                      |  |                                                        | 598   |                                                        |   | 434   |  
|Interest on securities  nontaxable                                                                   |  |                                                        | 160   |                                                        |   | 160   |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Total interest income                                                                                 |  |                                                        | 4,595 |                                                        |   | 3,908 |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Interest Expense:                                                                                     |  |                                                        |       |                                                        |   |       |  
|Interest on certificates of deposit > $100,000                                                        |  |                                                        | 262   |                                                        |   | 252   |  
|Interest on other deposits                                                                            |  |                                                        | 1,045 |                                                        |   | 751   |  
|Interest on long-term borrowings                                                                      |  |                                                        | 397   |                                                        |   | 397   |  
|Interest on repurchase agreements                                                                     |  |                                                        | 11    |                                                        |   | 11    |  
|Interest on federal funds purchased                                                                   |  |                                                        | 8     |                                                        |   |      |  
|Interest on guaranteed preferred beneficial interests in the Companys junior subordinated debentures |  |                                                        | 48    |                                                        |   | 43    |  
|Interest on short-term borrowings                                                                     |  |                                                        | 63    |                                                        |   | 37    |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Total interest expense                                                                                |  |                                                        | 1,834 |                                                        |   | 1,491 |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Net interest income                                                                                   |  |                                                        | 2,761 |                                                        |   | 2,417 |  
|                                                                                                      |  |                                                       
|Provision for loan losses                                                                             |  |                                                        | 331   |                                                        |   | 115   |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Net interest income after provision for loan losses                                                   |  |                                                        | 2,430 |                                                        |   | 2,302 |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Noninterest income:                                                                                   |  |                                                        |       |                                                        |   |       |  
|Service charges on deposit accounts                                                                   |  |                                                        | 209   |                                                        |   | 202   |  
|Income earned on bank owned life insurance                                                            |  |                                                        | 77    |                                                        |   | 71    |  
|Other income on real estate loans                                                                     |  |                                                        | 19    |                                                        |   | 47    |  
|Other fee income                                                                                      |  |                                                        | 40    |                                                        |   | 49    |  
|Losses on foreclosed properties                                                                       |  |                                                        |      |                                                        |   | (3    | )
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Total noninterest income                                                                              |  |                                                        | 345   |                                                        |   | 366   |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Noninterest expense:                                                                                  |  |                                                        |       |                                                        |   |       |  
|Compensation expense                                                                                  |  |                                                        | 1,017 |                                                        |   | 917   |  
|Occupancy expense                                                                                     |  |                                                        | 135   |                                                        |   | 97    |  
|Data processing and equipment expense                                                                 |  |                                                        | 237   |                                                        |   | 187   |  
|Franchise tax expense                                                                                 |  |                                                        | 46    |                                                        |   |      |  
|Purchased tax credit expense                                                                          |  |                                                        |      |                                                        |   | 34    |  
|Deposit expenses                                                                                      |  |                                                        | 44    |                                                        |   | 39    |  
|Loan expenses                                                                                         |  |                                                        | 108   |                                                        |   | 98    |  
|Other expense                                                                                         |  |                                                        | 292   |                                                        |   | 284   |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Total noninterest expense                                                                             |  |                                                        | 1,879 |                                                        |   | 1,656 |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Net income before taxes                                                                               |  |                                                        | 896   |                                                        |   | 1,012 |  
|                                                                                                      |  |                                                       
|Provision for income taxes                                                                            |  |                                                        | 230   |                                                        |   | 283   |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Net income                                                                                            |  | $                                                      | 666   |                                                        | $ | 729   |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Basic earnings per share                                                                              |  | $                                                      | 0.18  |                                                        | $ | 0.20  |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  
|Diluted earnings per share                                                                            |  | $                                                      | 0.17  |                                                        | $ | 0.19  |  
|                                                                                                      |  |                                                        |       |                                                        |   |       |  



See accompanying notes to consolidated
financial statements.



5



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##### Table of Contents

VALLEY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands, except
per share data)



|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------------------------- | ------- | - | --------------------------------------------------------- | - | ------- | -
|                                                                                                                    |  | For the Period January 1, 2004 Through September 30, 2004 |         |   | For the Period January 1, 2003 Through September 30, 2003 |  
|Cash Flows From Operating Activities:                                                                               |  |                                                           |         |   |                                                           |   |         |  
|Net income                                                                                                          |  | $                                                         | 1,970   |   |                                                           | $ | 2,043   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                                   |  |                                                           |         |   |                                                           |   |         |  
|Provision for loan losses                                                                                           |  |                                                           | 578     |   |                                                           |   | 471     |  
|Depreciation and amortization                                                                                       |  |                                                           | 474     |   |                                                           |   | 358     |  
|Tax benefit from exercise of stock options                                                                          |  |                                                           | 287     |   |                                                           |   |        |  
|Net gains on sale of securities                                                                                     |  |                                                           | (17     | ) |                                                           |   | (7      | )
|Net losses on sales of foreclosed properties                                                                        |  |                                                           | 8       |   |                                                           |   | 9       |  
|Net losses on disposals of fixed assets                                                                             |  |                                                           |        |   |                                                           |   | 7       |  
|Amortization (accretion) of premiums/discounts                                                                      |  |                                                           | 225     |   |                                                           |   | 169     |  
|Decrease in unearned fees                                                                                           |  |                                                           | (3      | ) |                                                           |   | (6      | )
|Increase in accrued interest receivable                                                                             |  |                                                           | (248    | ) |                                                           |   | (37     | )
|Increase in other assets                                                                                            |  |                                                           | (207    | ) |                                                           |   | (428    | )
|Increase in value of life insurance contracts                                                                       |  |                                                           | (226    | ) |                                                           |   | (199    | )
|Increase (decrease) in accrued interest payable                                                                     |  |                                                           | 303     |   |                                                           |   | (262    | )
|Increase (decrease) in other liabilities                                                                            |  |                                                           | 162     |   |                                                           |   | (146    | )
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Net cash provided by operating activities                                                                           |  |                                                           | 3,306   |   |                                                           |   | 1,972   |  
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Cash Flows From Investing Activities:                                                                               |  |                                                           |         |   |                                                           |   |         |  
|Increase (decrease) in short term investments                                                                       |  |                                                           | (253    | ) |                                                           |   | 3,575   |  
|Purchases of premises and equipment                                                                                 |  |                                                           | (429    | ) |                                                           |   | (1,066  | )
|Purchases of securities available for sale                                                                          |  |                                                           | (18,868 | ) |                                                           |   | (28,502 | )
|Purchases of securities held to maturity                                                                            |  |                                                           | (2,368  | ) |                                                           |   | (12,352 | )
|Purchases of restricted equity securities                                                                           |  |                                                           |        |   |                                                           |   | (716    | )
|Principal repays/sales/calls of securities available for sale                                                       |  |                                                           | 10,613  |   |                                                           |   | 7,291   |  
|Principal repays/calls of securities held to maturity                                                               |  |                                                           | 2,498   |   |                                                           |   | 10,223  |  
|Proceeds from sale of fixed assets                                                                                  |  |                                                           | 3       |   |                                                           |   |        |  
|Investment in life insurance contracts                                                                              |  |                                                           |        |   |                                                           |   | (1,200  | )
|Proceeds from sale of foreclosed properties                                                                         |  |                                                           | 276     |   |                                                           |   | 480     |  
|Capitalized foreclosed property expense                                                                             |  |                                                           |        |   |                                                           |   | (29     | )
|Increase in loans                                                                                                   |  |                                                           | (48,154 | ) |                                                           |   | (27,350 | )
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Net cash used in investing activities                                                                               |  |                                                           | (56,682 | ) |                                                           |   | (49,646 | )
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Cash Flows From Financing Activities:                                                                               |  |                                                           |         |   |                                                           |   |         |  
|Increase (decrease) in time deposits greater than $100,000                                                          |  |                                                           | 696     |   |                                                           |   | 7,997   |  
|Increase in other time deposits                                                                                     |  |                                                           | 41,540  |   |                                                           |   | 8,398   |  
|Increase in other deposits                                                                                          |  |                                                           | 11,908  |   |                                                           |   | 20,802  |  
|Increase (decrease) in short-term borrowings                                                                        |  |                                                           | (2,556  | ) |                                                           |   | 5,036   |  
|Increase (decrease) in securities sold under agreements to repurchase                                               |  |                                                           | 1,049   |   |                                                           |   | (585    | )
|Proceeds from Federal Home Loan Bank advances                                                                       |  |                                                           |        |   |                                                           |   | 7,000   |  
|Proceeds from issuance of guaranteed preferred beneficial interests in the Companys junior subordinated debentures |  |                                                           |        |   |                                                           |   | 4,000   |  
|Proceeds from issuance of common stock                                                                              |  |                                                           | 467     |   |                                                           |   | 29      |  
|Cash dividends paid                                                                                                 |  |                                                           | (227    | ) |                                                           |   |        |  
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Net cash provided by financing activities                                                                           |  |                                                           | 52,877  |   |                                                           |   | 52,677  |  
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Net Increase (decrease) in cash and due from banks                                                                  |  |                                                           | (499    | ) |                                                           |   | 5,003   |  
|Cash and due from banks at beginning of period                                                                      |  |                                                           | 7,511   |   |                                                           |   | 8,163   |  
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  
|Cash and due from banks at end of period                                                                            |  | $                                                         | 7,012   |   |                                                           | $ | 13,166  |  
|                                                                                                                    |  |                                                           |         |   |                                                           |   |         |  



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##### Table of Contents

VALLEY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(Unaudited)

(In thousands, except per share data)



|                                                  |  |                                                           |       |                                                           |   |      
|------------------------------------------------- |  | --------------------------------------------------------- | ----- | --------------------------------------------------------- | - | -----
|                                                  |  | For the Period January 1, 2004 Through September 30, 2004 |       | For the Period January 1, 2003 Through September 30, 2003
|Supplemental disclosure of cash flow information: |  |                                                           |       |                                                           |   |      
|Cash paid during the period for interest          |  | $                                                         | 4,700 |                                                           | $ | 4,527
|                                                  |  |                                                           |       |                                                           |   |      
|Cash paid during the period for taxes             |  | $                                                         | 523   |                                                           | $ | 744  
|                                                  |  |                                                           |       |                                                           |   |      
|Noncash financing and investing activities:       |  |                                                           |       |                                                           |   |      
|Transfer of loans to foreclosed property          |  | $                                                         | 283   |                                                           | $ | 264  
|                                                  |  |                                                           |       |                                                           |   |      



See accompanying notes to consolidated
financial statements.



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##### Table of Contents

VALLEY FINANCIAL CORPORATION



Notes
to Consolidated Financial Statements

September 30, 2004

(Unaudited)

(In thousands, except share and per share data)



|(1) | Organization and Summary of Significant Accounting Policies
|--- | -----------------------------------------------------------



Valley Financial Corporation (the Company) was incorporated under the laws of the Commonwealth of Virginia on March 15, 1994,
primarily to serve as a holding company for Valley Bank (the Bank), which opened for business on May 15, 1995. The Companys fiscal year end is December 31.



The consolidated financial statements of the Company conform to generally accepted accounting principles and
to general banking industry practices. The interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments of a normal recurring nature which are necessary for a fair presentation of the
consolidated financial statements herein have been included. The consolidated financial statements herein should be read in conjunction with the Companys 2003 Annual Report on Form 10-KSB.



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



|(2) | Cash and Cash Equivalents
|--- | -------------------------



For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks. To comply with Federal Reserve
regulations, the Bank is required to maintain certain average reserve balances. The daily cash reserve requirement for the week including September 30, 2004 was $974. As a condition of our correspondent bank agreement, the Bank is also required to
maintain a target balance. The target balance as of September 30, 2004 was $250.



|(3) | Securities
|--- | ----------



The carrying values, unrealized gains, unrealized losses and approximate fair values of available for sale and held to maturity investment
securities at September 30, 2004 are shown in the tables below. As of September 30, 2004 investments (including both available for sale and held to maturity) and restricted equity securities with amortized costs and fair values of $35,753 and
$35,920, respectively, were pledged as collateral for public deposits, a line of credit available from the Federal Home Loan Bank, customer sweep accounts, and for other purposes as required or permitted by law.



The following table sets forth the composition of securities
available for sale at September 30, 2004. Securities available for sale are carried at approximate market value.



8



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##### Table of Contents

Available for Sale Investment Portfolio  Category Distribution

(dollars in thousands)



|                                    |  |                 |        |                  |   |                   |  |   |                         |   |  |   |       
|----------------------------------- |  | --------------- | ------ | ---------------- | - | ----------------- |  | - | ----------------------- | - |  | - | ------
|                                    |  | Amortized Costs |        | Unrealized Gains |   | Unrealized Losses |  |   | Approximate Fair Values
|U.S. Government agencies            |  | $               | 10,388 |                  | $ | 114               |  | $ |                        |   |  | $ | 10,502
|Mortgage-backed securities          |  |                 | 7,394  |                  |   | 27                |  |   | (39                     | ) |  |   | 7,382 
|Collateralized mortgage obligations |  |                 | 20,004 |                  |   | 76                |  |   | (200                    | ) |  |   | 19,880
|States and political subdivisions   |  |                 | 9,936  |                  |   | 392               |  |   | (20                     | ) |  |   | 10,308
|Corporate debt securities           |  |                 | 200    |                  |   | 2                 |  |   | (1                      | ) |  |   | 201   
|                                    |  |                 |        |                  |   |                   |  |   |                         |   |  |   |       
|Total securities available for sale |  | $               | 47,922 |                  | $ | 611               |  | $ | (260                    | ) |  | $ | 48,273
|                                    |  |                 |        |                  |   |                   |  |   |                         |   |  |   |       



The
following table sets forth the composition of securities held to maturity at September 30, 2004. Securities held to maturity are carried at amortized cost.



Held to Maturity Investment Portfolio  Category Distribution

(dollars in thousands)



|                                    |  |                 |        |                  |   |                   |  |   |                         |   |  |   |       
|----------------------------------- |  | --------------- | ------ | ---------------- | - | ----------------- |  | - | ----------------------- | - |  | - | ------
|                                    |  | Amortized Costs |        | Unrealized Gains |   | Unrealized Losses |  |   | Approximate Fair Values
|U.S. Treasury                       |  | $               | 199    |                  | $ |                  |  | $ |                        |   |  | $ | 199   
|U.S. Government agencies            |  |                 | 9,928  |                  |   | 94                |  |   | (62                     | ) |  |   | 9,960 
|Mortgage-backed securities          |  |                 | 4,521  |                  |   | 33                |  |   | (7                      | ) |  |   | 4,547 
|Collateralized mortgage obligations |  |                 | 858    |                  |   |                  |  |   | (22                     | ) |  |   | 836   
|States and political subdivisions   |  |                 | 7,243  |                  |   | 123               |  |   | (47                     | ) |  |   | 7,319 
|                                    |  |                 |        |                  |   |                   |  |   |                         |   |  |   |       
|Total securities held to maturity   |  | $               | 22,749 |                  | $ | 250               |  | $ | (138                    | ) |  | $ | 22,861
|                                    |  |                 |        |                  |   |                   |  |   |                         |   |  |   |       



|(4) | Allowance for Loan Losses
|--- | -------------------------



The following table summarizes the loan loss experience for the nine-month periods ended September 30, 2004 and 2003.



Allowance for Loan Losses

(dollars in thousands)



|                                  |  |      |       |   |      |   |       |  
|--------------------------------- |  | ---- | ----- | - | ---- | - | ----- | -
|                                  |  | 2004 |       |   | 2003 |  
|Balance at January 1              |  | $    | 2,566 |   |      | $ | 2,014 |  
|Provision for loan losses         |  |      | 578   |   |      |   | 471   |  
|Recoveries  Loans to individuals |  |      |      |   |      |   | 1     |  
|Charged off loans                 |  |      |       |   |      |   |       |  
|Commercial                        |  |      | (104  | ) |      |   |      |  
|Credit Cards                      |  |      | (1    | ) |      |   |      |  
|Loans to individuals              |  |      | (16   | ) |      |   | (131  | )
|                                  |  |      |       |   |      |   |       |  
|Balance at September 30           |  | $    | 3,023 |   |      | $ | 2,355 |  
|                                  |  |      |       |   |      |   |       |  



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##### Table of Contents

|(5) | Earnings Per Share
|--- | ------------------



Basic earnings per share is based upon the weighted average number of common shares outstanding during the period. The weighted average
shares outstanding for the diluted earnings per share computations were adjusted to reflect the assumed conversion of shares available under stock options. The following table summarizes the shares utilized (adjusted for the two-for-one stock split
declared on April 28, 2004 to shareholders of record May 14, 2004 and paid on May 31, 2004) in the computations:



Weighted Average Shares Outstanding



|                                  |  |           |  |          
|--------------------------------- |  | --------- |  | ---------
|                                  |  | Basic     |  | Diluted  
|Nine months ending September 30:  |  |           |  |          
|2004                              |  | 3,726,988 |  | 3,981,501
|                                  |  |           |  |          
|2003                              |  | 3,661,300 |  | 3,889,434
|                                  |  |           |  |          
|                                  |  |          
|                                  |  | Basic     |  | Diluted  
|Three months ending September 30: |  |           |  |          
|2004                              |  | 3,798,665 |  | 4,006,616
|                                  |  |           |  |          
|2003                              |  | 3,662,952 |  | 3,917,782
|                                  |  |           |  |          



|(6) | Comprehensive Income
|--- | --------------------



On January 1, 1998, The Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income.This
Statement establishes standards for reporting and presentation of comprehensive income and its components in a full set of general purpose financial statements. This Statement was issued to address concerns over the practice of reporting elements of
comprehensive income directly in equity.



The
Company is required to classify items of Other Comprehensive Income (such as net unrealized gains on securities available for sale) by their nature in a financial statement. It does not require a specific format for that financial
statement but requires the Company to display an amount representing comprehensive income for the period in that financial statement. The Company is required to present the accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in-capital in the equity section of a statement of financial position. It does not require per share amounts of comprehensive income to be disclosed.



The adoption of Statement 130 on January 1, 1998 did not have any effect on the consolidated financial
position, results of operations or liquidity of the Company. However, Statement 130 does have an effect on financial statement displays presented by the Company since the Company has net unrealized gains on available for sale securities, an item of
other comprehensive income. For the nine months ended September 30, 2004 and 2003, total comprehensive income was $2,005 and $1,925, respectively. For the three months ended September 30, 2004 and 2003, total comprehensive income was $1,376 and
$378, respectively.



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##### Table of Contents

The information that follows discloses the reclassification adjustments and the income
taxes related to securities available-for-sale that are included in other comprehensive income, net of income taxes for the nine and three month periods ended September 30, 2004 and 2003.



|                                                                   |  |                                             |     |   |                                             |   |      |  
|------------------------------------------------------------------ |  | ------------------------------------------- | --- | - | ------------------------------------------- | - | ---- | -
|                                                                   |  | For the Nine Months EndedSeptember 30, 2004 |     |   | For the Nine Months EndedSeptember 30, 2003 |  
|Net unrealized gains (losses) on securities available for sale:    |  |                                             |     |   |                                             |   |      |  
|Net unrealized holding gains (losses) during the year              |  | $                                           | 70  |   |                                             | $ | (172 | )
|Less reclassification adjustments for gains included in net income |  |                                             | (11 | ) |                                             |   | (5   | )
|Income tax (expense) benefit                                       |  |                                             | (24 | ) |                                             |   | 59   |  
|                                                                   |  |                                             |     |   |                                             |   |      |  
|Other comprehensive income (loss), net of income taxes             |  | $                                           | 35  |   |                                             | $ | (118 | )
|                                                                   |  |                                             |     |   |                                             |   |      |  



|                                                                   |  |                                              |       |   |                                              |   |      |  
|------------------------------------------------------------------ |  | -------------------------------------------- | ----- | - | -------------------------------------------- | - | ---- | -
|                                                                   |  | For the Three Months EndedSeptember 30, 2004 |       |   | For the Three Months EndedSeptember 30, 2003 |  
|Net unrealized gains (losses) on securities available for sale:    |  |                                              |       |   |                                              |   |      |  
|Net unrealized holding gains during the quarter                    |  | $                                            | 1,076 |   |                                              | $ | (532 | )
|Less reclassification adjustments for gains included in net income |  |                                              |      |   |                                              |   |     |  
|Income tax (expense) benefit                                       |  |                                              | (366  | ) |                                              |   | 181  |  
|                                                                   |  |                                              |       |   |                                              |   |      |  
|Other comprehensive income (loss), net of income taxes             |  | $                                            | 710   |   |                                              | $ | (351 | )
|                                                                   |  |                                              |       |   |                                              |   |      |  



|(7) | Financial Instruments With Off-Balance Sheet Risk
|--- | -------------------------------------------------



In the normal course of business to meet the financing needs of its customers, the Company is a party to financial instruments with
off-balance-sheet risk, which involve commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.



The Companys exposure to credit loss in the event of
nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual amount of those instruments. The same credit policy is used in making commitments as is used for on-balance-sheet risk.
At September 30, 2004 outstanding commitments to extend credit were $75,234 as compared to $65,517 at December 31, 2003.



Commitments to extend credit are agreements to lend to a customer as long as there is no breach of any condition established in the
contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments may expire without ever being drawn upon; therefore, the total commitment amounts do not necessarily represent
future cash outlays for the Company.



|(8) | Related Party Transactions
|--- | --------------------------



The Bank has entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such
transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in
the opinion of management, involve more than normal credit risk or present other unfavorable features. As of September 30, 2004 aggregate loans to directors, executive officers and principal shareholders totaled $10,384.



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##### Table of Contents

|(9) | Long-Term Federal Home Loan Bank Advances
|--- | -----------------------------------------



The Company has outstanding long-term debt with the Federal Home Loan Bank of Atlanta in the amount of $37.0 million as of September 30, 2004. There are
four convertible advances in the amount of $5.0 million each and one convertible advance in the amount of $7.0 million and one $10.0 million convertible advance currently drawn. The Federal Home Loan Bank of Atlanta has the option to convert the
$37.0 million in convertible advances on the conversion dates below and any interest payment date thereafter with at least two business days notice. If called, the four $5.0 million convertible advances and the one $7.0 million convertible advance
will be converted into a 3-month LIBOR-based adjustable rate credit (ARC) at 3-month LIBOR flat. The $10.0 million convertible advance may be converted into a 3-month LIBOR-based floating rate advance (ARC) at 3-month LIBOR flat only if 3-month
LIBOR is greater than or equal to 7.0%. The following table provides more information on the outstanding advances as of September 30, 2004.



LONG-TERM FEDERAL HOME LOAN BANK ADVANCES



|                |  |                   |  |                   |  |      |   |  |                       |  |                              
|--------------- |  | ----------------- |  | ----------------- |  | ---- | - |  | --------------------- |  | -----------------------------
|Advance Balance |  | Advance Date      |  | Maturity Date     |  | Rate |   |  | Interest PaymentDates |  | First OptionalConversion Date
|$5,000,000      |  | December 2, 1999  |  | December 2, 2009  |  | 5.46 | % |  | Quarterly             |  | December 4, 2000             
|$5,000,000      |  | May 24, 2000      |  | May 24, 2010      |  | 6.49 | % |  | Quarterly             |  | May 24, 2001                 
|$5,000,000      |  | February 9, 2001  |  | February 9, 2011  |  | 4.97 | % |  | Quarterly             |  | February 9, 2004             
|$5,000,000      |  | November 7, 2001  |  | November 7, 2011  |  | 3.91 | % |  | Quarterly             |  | November 7, 2006             
|$10,000,000     |  | September 4, 2002 |  | September 4, 2007 |  | 3.09 | % |  | Quarterly             |  | September 4, 2003            
|$7,000,000      |  | March 11, 2003    |  | March 11, 2013    |  | 2.91 | % |  | Quarterly             |  | March 11, 2008               



|(10) | Guaranteed Preferred Beneficial Interests in the Companys Junior Subordinated Debentures
|---- | -----------------------------------------------------------------------------------------



Valley Financial (VA) Statutory Trust I, a statutory business trust (the Trust), was created by the Company on
September 26, 2003, at which time the Trust issued $4,000 in aggregate liquidation amount of $1 par value preferred capital trust securities which mature September 26, 2033. Distributions are payable on the securities at a floating rate equal to the
3-month LIBOR plus 3.10%, capped at 11.75%, and the securities may be prepaid at par by the Trust at any time after September 26, 2008. The principal assets of the Trust are $4,124 of the Companys junior subordinated debentures which mature on
September 26, 2033, bear interest at a floating rate equal to the 3-month LIBOR plus 3.10%, capped at 11.75%, and which are callable by the Company after September 26, 2008. All $124 in aggregation liquidation amount of the Trusts common
securities is held by the Company.



The Trusts preferred
securities and common securities may be included in the Companys Tier 1 capital for regulatory capital adequacy purposes to the extent that they do not exceed 25% of the Companys total Tier I capital excluding the securities. Amounts in
excess of this ratio will not be considered Tier 1 capital but may be included in the calculation of the Companys total risk-based capital ratio. The Companys obligations with respect to the issuance of the Trusts preferred
securities and common securities constitute a full and unconditional guarantee by the Company of the Trusts obligations with respect to the preferred securities and common securities. Subject to certain exceptions and limitations, the Company
may elect from time to time to defer interest payments on its junior subordinated debentures, which would result in a deferral of distribution payments on the Trusts preferred trust securities and common securities.



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|(11) | Stock Based Compensation
|---- | ------------------------



The Company accounts for its stock-based compensation plan using the accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees.The Company is not required to adopt the fair value based recognition provisions prescribed under SFAS No. 123, Accountingfor Stock Based Compensation, but complies with the disclosure requirements
set forth in the Statement (as amended by SFAS No. 148), which include disclosing pro forma net income as if the fair value based method of accounting had been applied.



Stock Option Plans



The Company has an Incentive Stock Plan (the Plan) pursuant to which the Human Resources Committee of the Companys Board of Directors may grant
stock options to officers and key employees. The Plan authorizes grants of options to purchase up to 311,850 shares (adjusted for stock splits) of the Companys authorized, but unissued common stock. Accordingly, 311,850 shares of authorized,
but unissued common stock are reserved for use in the Plan. There are options for 233,945 shares granted to officers and key employees currently outstanding as of September 30, 2004. All stock options have been granted with an exercise price equal
to the stocks fair market value at the date of the grant. Stock options generally have 10-year terms, vest at the rate of 20 percent per year, and become fully exercisable five years from the date of the grant. In addition, certain options for
182,196 shares (adjusted for stock splits) based on meeting certain performance criteria were granted to executive officers in 1997-1999. Options for 82,098 shares granted to executive officers remain unexercised as of September 30, 2004.
Information related to pro forma net income and per share (adjusted for stock splits) amounts for the periods presented is as follows:



|                                                                               |  |                                 |       |      |   |      
|------------------------------------------------------------------------------ |  | ------------------------------- | ----- | ---- | - | -----
|                                                                               |  | Nine Months Ended September 30,
|                                                                               |  | 2004                            |       | 2003
|Compensation cost recognized in income for all stock-based compensation awards |  | $                               |      |      | $ |     
|Pro forma net income, based on SFAS No. 123                                    |  | $                               | 1,925 |      | $ | 1,983
|Pro forma basic net income per share, based on SFAS No. 123                    |  | $                               | .52   |      | $ | .54  
|Pro forma diluted net income per share, based on SFAS No. 123                  |  | $                               | .48   |      | $ | .51  
|                                                                               | 
|                                                                               |  | Quarter Ended September 30,    
|                                                                               |  | 2004                            |       | 2003
|Compensation cost recognized in income for all stock-based compensation awards |  | $                               |      |      | $ |     
|Pro forma net income, based on SFAS No. 123                                    |  | $                               | 651   |      | $ | 709  
|Pro forma basic net income per share, based on SFAS No. 123                    |  | $                               | .17   |      | $ | .19  
|Pro forma diluted net income per share, based on SFAS No. 123                  |  | $                               | .16   |      | $ | .18  



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##### Table of Contents

Item 2. Managements Discussion and Analysis.



The following is managements discussion and analysis of the financial condition and results of operations of the Company as of and for the nine months and the quarters ended September 30, 2004 and 2003. The
discussion should be read in conjunction with the Companys Consolidated Financial Statements and Notes thereto.



Forward-Looking Statements



This report contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from
those reflected in such forward-looking statements, which are representative only on the date hereof. Readers of this report should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed
throughout this report. The Corporation takes no obligation to update any forward-looking statements contained herein. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include,
among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins; (3) general economic conditions,
either nationally or regionally, may be less favorable than expected that could result in a deterioration of credit quality or a reduced demand for credit; (4) legislative or regulatory changes including changes in accounting standards, may
adversely affect the business.



Overview



The Company was incorporated as a Virginia stock corporation on March 15,
1994, primarily to own and control all of the capital stock of the Bank. The Bank opened for business on May 15, 1995. There are currently seven full-service offices operating in various locations throughout the Cities of Roanoke and Salem and the
County of Roanoke. Amounts are in thousands unless otherwise noted.



Total assets at September 30, 2004 were $364.7 million, up 18.0% from $309.0 million at December 31, 2003. The principal components of the Companys assets at September 30, 2004 were $51.4 million in securities available for sale,
including restricted equity securities, $22.7 million in securities held to maturity, and $270.4 million in gross loans.



Total liabilities at September 30, 2004 were $340.6 million, up 18.5% from $287.4 million at December 31, 2003 with the increase represented by $54.1
million growth in deposits and $1.0 million growth in securities sold under agreements to repurchase.



Total shareholders equity at September 30, 2004 was $24.1 million consisting of $9.1 million in net proceeds from the Companys initial public
offering, $3.2 million in net proceeds from the Companys secondary offering, $577 in proceeds from the exercise of stock options and $287 deferred tax benefit from the exercise of stock options, all increased by accumulated retained earnings
of $10.7 million and $232 of unrealized appreciation on securities available-for-sale, net of related deferred tax liability. Total shareholders equity was $24.1 million at September 30, 2004 compared with $21.6 million at December 31, 2003,
an increase of $2.5 million or 11.6%. Exclusive of unrealized gains on investment securities, shareholders equity was $23.9 million at September 30, 2004 and $21.4 million at December 31, 2003.



The Company had net income of $1,970 for the nine months ended September 30,
2004, a decrease of $73 or 3.6% from the nine months ended September 30, 2003. Net income for the three months ended September 30, 2004 was $666, a 8.6% decrease from the $729 recorded for the third quarter



14



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##### Table of Contents

of 2003. The biggest factors contributing to the decline in net income for both periods were shrinkage in the net
interest margin as yields on earning assets declined faster than costs could be reduced, and increases in noninterest expense in virtually all categories.



Profitability as measured by the Companys return on average assets (ROA) was 0.78% for the nine months ended September 30, 2004 compared
to 1.00% for the same period in 2003. ROA for the third quarter of 2004 was 0.74% versus 0.99% for the third quarter of 2003. Return on average equity (ROE) was 11.61% for the nine months ended September 30, 2004 compared to 13.78% for
the same period in 2003. ROE for the third quarter of 2004 was 11.13% as compared to 14.08% for the third quarter of 2003. The calculation of ROE excludes the effect of any unrealized gains or losses on investment securities.



Net Interest Income



Net interest income is the amount by which interest and fees generated from loans and investments exceeds the interest
expense associated with funding those assets, and represents the principal source of earnings for the Company. Changes in the volume and mix of earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a
significant impact on the level of net interest income. Changes in the interest rate environment and the Companys cost of funds also affect net interest income.



Net interest income was $7.9 million for the nine months ended September 30, 2004 and is attributable to interest income
from loans and securities exceeding the cost of interest paid on deposits and borrowed funds. Net interest income for the first nine months of 2004 increased 12.8% from $7.0 million for the same period in 2003. The net interest margin on a fully
taxable equivalent (FTE ) basis was 3.40% for the first nine months of 2004, a decrease of 40 basis points from the 3.80% reported for the same period in 2003. Yields on earning assets decreased faster than funding costs could be
reduced. The Banks cost of funds ratio was 2.13% for the nine months ended September 30, 2004, down 13 basis points from the 2.26% reported for the first nine months of 2003. The Banks yield on earning assets was 5.50% for the nine
months ended September 30, 2004, down 54 basis points from the 6.04% reported for the nine months ended September 30, 2003. For the three months ended September 30, 2004 net interest income was $2.8 million, an increase of 14.2% from the $2.4
million reported for the three months ended September 30, 2003. The FTE net interest margin was 3.34% and 3.64% for the three month periods ended September 30, 2004 and 2003, respectively. Management is working to maintain the net interest margin by
reducing the cost of funds ratio, a task made more difficult by the fact that deposit rates have almost reached a practical floor and the Banks relative reliance on higher-cost certificates of deposit to fund rapid growth in earning assets.



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##### Table of Contents

Noninterest Income



Noninterest income for the nine months ended September 30, 2004 was $1,005 a decrease of $5 or 0.5% over the $1,010 reported for the same period one year
earlier. Securities gains totaled $17 during the first nine months of 2004 as compared to $7 for the first nine months of 2003. For the three months ended September 30, 2004 noninterest income was $345, a decrease of $21 or 5.74% from the $366
reported for the third quarter of 2003. The reason for the decline in noninterest income for the third quarter is a decrease of $28 in real estate loan income as compared to the same period in 2003. Future levels of noninterest income are expected
to increase as a direct result of business growth and expansion.



Noninterest Expense



Noninterest expense for
the first nine months of 2004 was $5.6 million, an increase of $723 or 14.7% over the $4.9 million reported for the same period in 2003. Compensation expense was the largest contributor to the increase in the amount of $349. The second largest
contributor to the increase was data processing and equipment expense in the amount of $153. For all of 2003 and a portion of 2004 the Bank owned and wrote off certain purchased tax credits. As a result, franchise tax expense increased by $124 in
the first nine months of 2004, which was more than offset by a reduction in purchased tax credit expense. Certain operating expenses associated with the opening of the Banks seventh full-service branch in December 2003 are included in the nine
months ended September 30, 2004. Substantially all major categories of noninterest expense increased in the first nine months due to growth and expansion. Noninterest expense for the quarter ended September 30, 2004 was $1.9 million, an increase of
$223 or 13.5% over the $1.7 million reported for the third quarter of 2003. Substantially all major categories of noninterest expense increased in the third quarter due to growth and expansion. Noninterest expenses are expected to increase in future
years as a direct result of business growth and expansion.



Income Taxes



To reflect the Companys anticipated federal income
tax liability, an expense of $689 and $598 at an effective tax rate of 25.9% and 22.6% was recognized for the nine months ended September 30, 2004 and September 30, 2003, respectively. The provision for income taxes for the third quarter of 2004 and
2003 was $230 and $283 at an effective tax rate of 25.7% and 27.0%, respectively. During the first quarter of 2003, the Bank purchased federal and state tax credits in the amounts of $174 and $217, respectively. The federal and state tax credits
were purchased at a total cost of $156 and $151, respectively. The credits were expensed in the amount of $248 during the first nine months of 2003, comprised of $156 federal and $58 state, as purchased tax credit expense (a noninterest expense).
The federal tax credits partially offset federal income tax expense in 2003, while the state tax credits partially offset Virginia bank franchise tax expense in 2003 and will do so again in 2004 and for several years beyond. Other factors
contributing to the difference between the effective tax rate and the statutory rate of 34% include tax-exempt interest income on municipal securities, net of disallowance, and tax-exempt income earned on bank-owned life insurance.



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##### Table of Contents

Investment Securities



The Companys investment portfolio is used both for investment income and liquidity purposes. Funds not used for capital expenditures or lending
activities are invested in securities of the U.S. Government and its agencies, mortgage-backed securities, municipal bonds, corporate bonds, and equity securities. Obligations of the U.S. Government and its agencies include treasury notes and
callable or noncallable agency bonds. Mortgage-backed securities and collateralized mortgage obligations include pools issued by government agencies and corporate mortgage pools. Municipal bonds include taxable and tax-exempt general obligation and
revenue issues. Corporate bonds are investment grade issue. Equity securities include shares of the Federal Reserve Bank of Richmond, Federal Home Loan Bank of Atlanta, and Community Bankers Bank. The Company does not invest in derivatives or other
types of high-risk securities.



Investment securities
(available for sale and held to maturity), including restricted equity securities, at September 30, 2004 were $74.2 million, an increase of $8.0 million or 12.4% from their level of $66.2 million on December 31, 2003. The increase is primarily due
to purchases in the amount of $21.2 million, offset by principal repayments, sale proceeds, and called proceeds in the amounts of $6.6 million, $5.5 million and $1.0 million, respectively. An increase in unrealized gains on securities in the
available for sale portfolio, which is carried at approximate fair market value, accounted for a portion of the increase. See Note 3 to the Consolidated Financial Statements.



Loan Portfolio



The Companys total loans were $270.4 million at September 30, 2004, an increase of $47.8 million or 21.5% from the $222.6 million reported at
December 31, 2003. The Companys ratio of total loans to total funding sources (customer deposits, securities sold under agreements to repurchase, federal funds purchased, Federal Home Loan Bank advances, and guaranteed preferred beneficial
interests in the Companys junior subordinated debentures) stood at 79.8% at September 30, 2004 and 77.8% at December 31, 2003. Management seeks to maintain the ratio of loans to funding sources at less than 85%.



The loan portfolio primarily consists of commercial, real estate (including
real estate term loans, construction loans and other loans secured by real estate) and loans to individuals for household, family and other consumer purposes. The Company adjusts its mix of lending and the terms of its loan programs according to
economic and market conditions, asset/liability management considerations and other factors. Loans typically (in excess of 90%) are made to businesses and individuals located within the Companys primary market area, most of whom maintain
deposit accounts with the Bank. There is no concentration of loans exceeding 10% of total loans, which is not disclosed in the Consolidated Financial Statements and the Notes thereto or discussed below.



The following table summarizes the loan portfolio by category as of the
nine-month period ended September 30, 2004 and the year ended December 31, 2003.



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Loan Portfolio Summary

(dollars in thousands)



|                          |  |                   |         |                  |   |        
|------------------------- |  | ----------------- | ------- | ---------------- | - | -------
|                          |  | September 30,2004 |         | December 31,2003
|Commercial and industrial |  | $                 | 68,239  |                  | $ | 53,141 
|Commercial real estate    |  |                   | 104,162 |                  |   | 92,563 
|Real estate construction  |  |                   | 23,291  |                  |   | 17,622 
|Residential real estate   |  |                   | 40,290  |                  |   | 29,959 
|Loans to individuals      |  |                   | 34,371  |                  |   | 29,318 
|                          |  |                   |         |                  |   |        
|Total loans               |  | $                 | 270,353 |                  | $ | 222,603
|                          |  |                   |         |                  |   |        



Loan Category Analysis



Commercial Loans. Commercial and industrial loans
accounted for 25.2% of the loan portfolio as of September 30, 2004 and stood at $68.2 million versus $53.1 million nine months earlier. Such loans generally are made to provide operating lines of credit, to finance the purchase of inventory or
equipment, and for other business purposes. The creditworthiness of the borrower is analyzed and re-evaluated on a periodic basis. Most commercial loans are collateralized with business assets such as accounts receivable, inventory and equipment.
Even with substantial collateral such as all the assets of the business and personal guarantees, commercial lending involves considerable risk of loss in the event of a business downturn or failure of the business.



Commercial Real Estate Loans.Commercial real estate construction and
commercial real estate mortgages represent interim and permanent financing of commercial properties that are secured by real estate, and were 38.5% of total loans at September 30, 2004. Outstanding loans in this category equaled $104.2 million and
$92.6 million at September 30, 2004 and December 31, 2003, respectively. The Company prefers to make commercial real estate loans secured by owner-occupied properties. These borrowers are engaged in business activities other than real estate, and
the primary source of repayment is not solely dependent on conditions in the real estate market.



Real Estate Construction Loans. Real estate construction loans represent interim financing on residential and commercial properties under
construction, and are secured by real estate. Once construction is completed and the loan becomes permanent, the loans are reclassified as commercial real estate loans, which are secured by commercial property or residential real estate loans, which
are secured by first deeds of trust on one to four family residential properties. Outstanding loans in this category totaled $23.3 million (8.6% of total loans) at September 30, 2004 as compared to $17.6 million at December 31, 2003.



Residential Real Estate Loans. Residential real estate loans are
secured by first deeds of trust on 1-4 family residential properties. This category had $40.3 million in loans (14.9% of total loans) at September 30, 2004 and $30.0 million in such loans at December 31, 2003. To mitigate interest rate risk, the
Company usually limits the final maturity of residential real estate loans held for its own portfolio to 15-20 years. Residential real estate lending involves risk elements when there is lack of timely payment and/or a decline in the value of the
collateral.



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##### Table of Contents

Loans to Individuals.Loans to individuals include installment loans and home equity lines of
credit/loans secured by junior liens on residential real estate. The loan proceeds typically are used to purchase vehicles, finance home remodeling or higher education, or for other consumer purposes. Loans to individuals totaled $34.4 million
(12.7% of total loans) at September 30, 2004 compared to $29.3 million at December 31, 2003.



Summary of Allowance for Loan Losses



Certain credit risks are inherent in making loans. The Company seeks to prudently assess these risks and attempts to manage them effectively. Adhering to our internal credit policies and procedures reduces repayment
risks. These policies and procedures include officer and customer limits, periodic loan documentation review, and follow-up on exceptions to credit policies.



The allowance for loan losses is maintained at a level estimated to be adequate to absorb probable losses. Some of the factors which management considers
in determining the appropriate level of the allowance for loan losses are an evaluation of the current loan portfolio, identified loan problems, loan volume outstanding, past loss experience, present and expected industry and economic conditions
and, in particular, how such conditions relate to our market area. Bank regulators also periodically review the loan portfolio and other assets to assess their quality. The provision for loan losses is charged to income in an amount believed to be
necessary to maintain an allowance for loan losses adequate to provide for expected losses in the loan portfolio. Loans deemed uncollectible are charged to the allowance for loan losses and recoveries on loans previously charged off are added to the
allowance for loan losses. The Company believes the allowance for loan losses is adequate to provide for expected losses in the loan portfolio.



No assurance can be given that unforeseen adverse economic conditions or other circumstances will not result in increased provisions in the future.
Additionally, regulatory examiners may require the Company to recognize additions to the allowance based upon their judgment about the loan portfolio and other information available to them at the time of their examinations.



A provision for loan losses of $578 was provided during the nine months ended
September 30, 2004, a decrease of $107 or 22.7% over the same period in 2003, in recognition of managements estimate of inherent risks associated with lending activities. The allowance for loan losses was $3.0 million as of September 30, 2004
and represented approximately 1.13% of net loans outstanding versus 1.17% of net loans at December 31, 2003 (see Note 4 to the Consolidated Financial Statements). A total of $108 in specific reserves is included in the balance of the allowance for
loan losses as of September 30, 2004. A total of $24 in specific reserves is included in the balance of the allowance for loan losses as of September 30, 2003. For the three months ended September 30, 2004 a provision for loan losses of $331 was
made versus $115 during the same period in 2003, a 187.8% increase of $216. The increase in the quarterly provision expense is due to rapid growth in outstanding loan balances.



Nonperforming Assets and Impaired Loans



Nonperforming Assets.Nonperforming assets include nonaccrual loans, loans past due 90 days or more, restructured loans and foreclosed/repossessed
property. A loan will be placed on nonaccrual status when collection of all principal or interest is deemed unlikely. A loan will automatically be placed on nonaccrual status when principal or interest is past due 90 days or more, unless the loan is
both well secured and in the process of being collected. In this case, the loan will continue to accrue interest despite its past due status.



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A restructured loan is a loan in which the original contract terms have been modified due to a
borrowers financial condition or there has been a transfer of assets in full or partial satisfaction of the loan. A modification of original contractual terms is generally a concession to a borrower that a lending institution would not
normally consider. The entire balance of restructured loans as disclosed below is comprised of one loan customer. Due to a good loan to value ratio, a timely and proper review of credit quality and restructuring of the loan, the Company was able to
collect all amounts of principal and interest.



An impaired
loan as defined in SFAS 114 is a loan when, based on current information and events, it is likely that a lending institution will be unable to collect all amounts, including both principal and interest, due according to the contractual terms of the
loan agreement.



Each quarter the board of directors reviews
all loans on the Banks watch list to determine proper action and reporting of any loans identified as substandard by the credit quality review.



The total recorded investment in impaired loans was $236, $1,246 and $88, respectively for the nine month period ended September 30, 2004, the year ended
December 31, 2003 and the nine-month period ended September 30, 2003. The loan loss allowance related to impaired loans was $108, $30 and $24, respectively for the above-referenced time periods. Management believes that the above allocated reserves
are adequate for the impaired loans in the Companys portfolio based upon a detailed review of the quality and pledged collateral of each individual loan considered impaired at each of the above-referenced periods.



Nonperforming assets at September 30, 2004, December 31, 2003 and September
30, 2003 are presented in the following table.



Nonperforming
Assets

(dollars in thousands)



|                                             |  |                   |     |                  |   |                   |  |   |   
|-------------------------------------------- |  | ----------------- | --- | ---------------- | - | ----------------- |  | - | --
|                                             |  | September 30,2004 |     | December 31,2003 |   | September 30,2003
|Nonaccrual loans                             |  | $                 | 236 |                  | $ | 1,094             |  | $ | 88
|Loans past due 90 days or more               |  |                   |    |                  |   |                  |  |   |  
|Restructured loans                           |  |                   |    |                  |   | 151               |  |   |  
|                                             |  |                   |     |                  |   |                   |  |   |   
|Total nonperforming loans                    |  |                   | 236 |                  |   | 1,246             |  |   | 88
|                                             |  |                   |     |                  |   |                   |  |   |   
|Foreclosed, repossessed and idled properties |  |                   | 12  |                  |   |                  |  |   |  
|                                             |  |                   |     |                  |   |                   |  |   |   
|Total nonperforming assets                   |  | $                 | 248 |                  | $ | 1,246             |  | $ | 88
|                                             |  |                   |     |                  |   |                   |  |   |   



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If nonaccrual loans had performed in accordance with their original terms, additional interest income in
the amount of $7, $18 and $10, respectively would have been recorded for the nine-month period ended September 30, 2004, the year ended December 31, 2003 and the nine-month period ended September 30, 2003.



Other Assets



The Company has purchased life insurance contracts on key employees, the tax-exempt income from which is the funding vehicle
for the Companys SERP plan. Bank owned life insurance was $6.1 million at September 30, 2004, an increase of $226 over the $5.8 million reported as of December 31, 2003.



Other assets were $1.6 million at September 30, 2004, an increase of $125 over the $1.5 million reported as of December 31,
2003.



Deposits



As of September 30, 2004 total deposits were $277.2 million, an increase of
$54.2 million or 24.3% from their level of $223.0 million at December 31, 2003. Certificates of deposit increased by $42.2 million to a total of $178.2 million (64.3% of total deposits) at September 30, 2004, up from $135.9 million (60.9% of total
deposits) at December 31, 2003. Compared with year-end 2003, non-interest bearing demand deposits and money market accounts increased by $6.8 million and $4.8 million, respectively, while interest bearing demand deposits increased $8 and savings
deposits increased $343. The Company would prefer to have transaction accounts comprise a larger percentage of total deposits but in order to fund double-digit loan growth, often has to rely on higher-cost certificates of deposit. Within the
certificate of deposit category, the Company has subscribed this year to an Internet-based rate posting service that allows it to market CDs nationally to institutional depositors, primarily banks, thrift institutions and credit unions. National
market CDs at September 30, 2004 were $18.6 million, representing 10.4% of total CDs and 6.7% of total deposits.



At September 30, 2004 noninterest-bearing demand deposits were $43.5 million or 15.7% of total deposits. On December 31, 2003 noninterest-bearing demand
deposits were $36.7 million or 16.4% of total deposits. Nonmaturity deposits (noninterest bearing demand deposits, interest bearing demand deposits, money market accounts and savings accounts) were $102.0 million or 36.8% of total deposits at
September 30, 2004 compared with $87.1 million or 39.1% of total deposits at December 31, 2003. Total interest bearing deposits stood at $233.7 million at September 30, 2004, an increase of $47.3 million or 25.4% over their level of $186.4 million
at December 31, 2003.



The levels and mix of deposits are
influenced by such factors as customer service, interest rates paid, service charges and the convenience of banking locations. Competition for deposits is intense from other depository institutions and money market funds, some of which offer
interest rates higher than those paid by the Company. Management attempts to identify and implement pricing and marketing strategies designed to control the overall cost of deposits and to maintain a stable deposit mix.



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Short-Term Borrowings



The Company has in place a commercial sweep account program as a cash management service for commercial customers. The balance in the program grew by $1.1
million from its level of $4.7 million at December 31, 2003 to a total of $5.8 million as of September 30, 2004. The program consists of establishing a demand deposit account in which the Bank invests available balances daily in securities on an
overnight basis subject to repurchase. On the following business day, the Bank will repurchase from the customer the securities for an amount equal to the amount of available balances invested in the securities. Interest is calculated daily at the
rate applicable for each overnight period; however, it is posted to the customer accounts only once per month. The contractual agreement states that a repurchase agreement is not a deposit and therefore is not insured by the Federal Deposit
Insurance Corporation. Therefore, these repurchase balances are not reported as deposits but as short-term borrowings.



In addition to the commercial sweep accounts, the Company at September 30, 2004 and December 31, 2003 had $10 million in a term FHLB advance with a
maturity under one year. The Company also had at September 30, 2004 $5.0 million in overnight borrowings, down $2.6 million or 34.2% from their level of $7.6 million at December 31, 2003. See the Liquidity section for further information on the
preceding borrowings.



Other Debt



Federal Home Loan Bank advances are relatively cost-effective funding
sources and provide the Company with the flexibility to structure borrowings in a manner that aids in the management of interest rate risk and liquidity. Long-term Federal Home Loan Bank advances totaled $37.0 million at September 30, the same
amount outstanding as of December 31, 2003.



Guaranteed
preferred beneficial interests in the Companys junior subordinated debentures are hybrid securities, which are considered equity for regulatory purposes and debt for financial statement and tax purposes. Guaranteed preferred beneficial
interests in the Companys junior subordinated debentures offer the benefit of an attractive floating or fixed rate interest payment which is tax deductible, making the after-tax cost to the issuer less than traditional forms of capital. The
$4.0 million debt was effective June 26, 2003 with a stated term of 30 years. Quarterly interest payments began September 26, 2003. The debt carries an interest rate of 3-Month LIBOR plus 3.10%, currently 5.05%, which resets quarterly on each
interest payment date.



Interest Rate Risk



Interest rate risk is the risk to earnings or capital generated by the
effects of changes in interest rates on the Companys on- and off-balance sheet positions, and can take one or more of several forms. Repricing risk comes from timing mismatches in the ability to alter contractual rates earned on financial
assets held or paid on interest-bearing liabilities. Basis risk refers to changes in the underlying relationships between market rates or indices, which result in a narrowing of the spread earned on a loan or investment relative to its cost of
funds. Option risk arises from embedded options in many financial instruments such as interest rate options, loan prepayment options, deposit early withdrawal options, callable Federal Home Loan Bank advances and potential prepayment of
the underlying collateral of asset-backed securities. Embedded options are complex risk positions that are difficult to predict and offset, and are a large component of the overall interest rate risk to the Company.



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The Company has established risk measures, limits, policy guidelines and internal control mechanisms for
managing the overall asset/liability management (ALM) position. The responsibility for interest rate risk control resides with Management, with oversight by the Board of Directors and its Investment Committee. The Company seeks to
balance the return potential of the ALM position against the desire to limit volatility in earnings.



At least quarterly, the Company measures the ALM position using earnings simulation modeling to estimate what assets and liabilities would reprice, and to
what extent, within a one-year period in response to an immediate 200 basis point change in the Prime Rate. The Companys objective is to keep the change in net interest income over twelve months at or below 10%, and the change in net income at
or below 20%, under an immediate 200 basis point interest rate shock scenario. Longer-term exposure to changes in interest rates is measured by estimating the Economic Value of Equity (EVE), the net present value of the balance
sheets cash flow or the residual value of future cash flows, under various rate scenarios. The Companys objective is to keep the change in EVE under a 300 basis point rate shock below 25%. The ALM model also incorporates
managements forecasts for balance sheet growth, noninterest income and noninterest expense. The interest rate scenarios are used for analytical purposes and do not necessarily represent managements view of future market movements.
Rather, these are intended to provide a measure of the degree of volatility interest rate movements may apply to the earnings of the Company. Modeling the sensitivity of earnings to interest rate risk is highly dependent on numerous assumptions
embedded in the simulation model. While the earnings and EVE sensitivity analyses incorporate Managements best estimate of interest rate and balance sheet dynamics under various market rate movements, the actual behavior and resulting earnings
and EVE impact likely will differ from that projected.



Capital Adequacy



The Companys financial position at September 30,
2004 reflects liquidity and capital levels currently adequate to fund anticipated near-term business expansion. Capital ratios are in excess of required regulatory minimums for a well-capitalized institution. The adequacy of the Companys
capital is reviewed by management on an ongoing basis. Management seeks to maintain a capital structure adequate to support anticipated asset growth and serve as a cushion to absorb potential losses.



Total shareholders equity increased by $2.5 million during the first
nine months of 2004. The increase is attributable to net income for the first nine months of $1,970, $754 in proceeds from the exercise of stock options and a $35 increase in accumulated other comprehensive income, partially offset by $227 in cash
dividends declared. Exclusive of unrealized gains on investment securities, shareholders equity was $23.9 million at September 30, 2004 and $21.4 million at December 31, 2003.



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##### Table of Contents

For the periods indicated, the Company had the following risk-based capital and leverage ratios:



Capital Ratios



|         |  |         |   |  |          |   |  |         |  
|-------- |  | ------- | - |  | -------- | - |  | ------- | -
|Ratio    |  | 9/30/04 |   |  | 12/31/03 |   |  | 9/30/03 |  
|Tier 1   |  | 9.3     | % |  | 10.3     | % |  | 10.5    | %
|Total    |  | 10.4    | % |  | 11.3     | % |  | 11.5    | %
|Leverage |  | 7.8     | % |  | 8.4      | % |  | 8.5     | %



Stock Offering



We have grown rapidly since our formation and we now need additional equity
capital to support future growth. Since the end of 2000, our assets have more than doubled to $365 million at September 30, 2004. We have strived to enhance shareholder value by leveraging our existing capital; however, without additional equity
capital our ability to grow will be constrained. Our goal is to leverage the capital from the following offering in a manner that enhances future earnings per share and shareholder value.



In September 2004, the Company entered into a stock purchase agreement for 275,000 shares of its authorized and unissued
common stock, to be purchased by Nicholas F. Taubman, Mozart One, LLC and Mozart Three, LLC. Mozart One, LLC and Mozart Three, LLC are limited liability companies affiliated with the Taubman family. The transaction was completed on November 4, 2004.
Mr. Taubman is a prominent Roanoke businessman and investor. He is a director and the retired CEO of Advance Auto.



Liquidity



Asset/liability management activities are designed to ensure that adequate liquidity is available to meet loan demand or deposit outflows and, through the
management of the Companys interest sensitivity position, to manage the impact of interest rate fluctuations on net interest income.



Liquidity measures the ability of the Company to meet its maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to
fund its operations and to provide for customers credit needs. Liquidity represents a financial institutions ability to meet present and future financial obligations through either the sale or maturity of existing assets or the
acquisition of additional funds from alternative funding sources.



Cash and due from banks, money market investments, investments available for sale (including restricted equity securities) and investment maturities/prepayments and loan repayments, provide the Companys asset liquidity. The
Companys ratio of liquid assets to deposits and short-term borrowings was 19.9% at September 30, 2004 and 20.9% at December 31, 2003. From time to time the Company sells excess funds as overnight federal funds sold to provide an immediate
source of liquidity. The Company had $621 in federal funds sold at September 30, 2004 versus none at December 31, 2003. During the first nine months of 2004, deposit growth in the amount of $54.1 million surpassed the $47.8 million loan growth
experienced. The excess $6.3 million along with the increase in securities sold under agreements to repurchase in the amount of $1.1 million was used to fund investment purchases in excess of principal paydowns, sales and calls proceeds of
approximately $7.9 million.



The level of deposits may
fluctuate, perhaps significantly so, due to seasonal cycles of depositing



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##### Table of Contents

customers and the promotional activities of competitor financial institutions. Similarly, the level of demand for loans
may vary significantly and at any given time may increase or decrease substantially. However, unlike the level of deposits, management has more direct control over lending activities and if necessary can adjust the level of those activities
according to the amounts of available funds.



In addition to
asset liquidity, the Company would have liquidity available to it through increasing certain categories of liabilities. It could purchase overnight federal funds, borrow from correspondent banks, sell securities under a repurchase agreement or
obtain advances from the Federal Home Loan Bank. The Bank also has established a credit line through the discount window of the Federal Reserve Bank of Richmond as an additional source of cash flow. As a result of the Companys management of
liquid assets and the ability to generate liquidity through alternative funding sources, management believes the Company maintains overall liquidity sufficient to meet its depositors requirements and satisfy its customers credit needs.



Impact of Inflation



The Consolidated Financial Statements and Notes thereto presented herein
have been prepared in accordance with generally accepted accounting principles, which requires the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of
money over time due to inflation. Unlike most industrial companies, nearly all the assets and liabilities of the Company and the Bank are monetary in nature. As a result, interest rates have a greater impact on the Companys performance than do
the effects of changes in the general rate of inflation and changes in prices. In addition, interest rates do not necessarily move in the same direction or in the same magnitude as do the prices of goods and services. Management seeks to manage the
relationship between interest-sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations, including those resulting from inflation.



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##### Table of Contents

Item 3. Controls and Procedures.



As of the end of the period covered by this report, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, including internal controls and procedures for financial reporting.
Our principal executive officer and principal financial officer supervised this evaluation and concluded that our disclosure controls and procedures are effective. Subsequent to this evaluation, (i) there have not been any significant changes to our
internal controls or other factors that could significantly affect our disclosure controls or procedures and (ii) we have not taken any corrective actions with respect to our disclosure controls and procedures to correct any significant deficiencies
or weaknesses.



The design of any system of controls is based in part upon
certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goal under every potential condition, regardless of how remote. In addition, the operation of any system of
controls and procedures is dependent upon the employees responsible for executing it. While we have evaluated the operation of our disclosure controls and procedures and found them effective, there can be no assurance that they will succeed in every
instance to achieve their objective.



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##### Table of Contents

PART II. OTHER INFORMATION



Item 4. Submission of Matters to a Vote of Security Holders.



None



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##### Table of Contents

Item 5. Other Information.



None.



Item 6. Exhibits and Reports on Form 8-K.



|(a) | The Company filed the following exhibits for the quarter ended September 30, 2004:
|--- | ----------------------------------------------------------------------------------



Exhibits:



|      |  |                                                                                                                                                                                                                                                                                        
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1   |  | Articles of Incorporation (incorporated herein by reference to Exhibit No. 3.1 of Registration Statement No. 33-77568, on form S-1, as amended).                                                                                                                                       
|      | 
|3.2   |  | Bylaws (incorporated herein by reference to Exhibit No. 3.2 of Registration Statement No. 33-77568, on form S-1, as amended).                                                                                                                                                          
|      | 
|*10.2 |  | Employment Agreement dated April 8, 1994, by and between the Company and A. Wayne Lewis (incorporated herein by reference to Exhibit No. 10.2 of Registration Statement No. 33-77568, on Form
S-1, as amended).                                                                        
|      | 
|*10.3 |  | Severance Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.3 of Form 10-KSB filed March 27, 1997, File
No. 33-77568).                                                                           
|      | 
|*10.4 |  | Stock Option Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.4 of Form 10-KSB filed March 27, 1997,
File No. 33-77568).                                                                        
|      | 
|10.5  |  | Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated herein by reference to Exhibit No. 10.5 of Registration
Statement No. 33-77568, on Form S-1, as amended).                                       
|      | 
|10.10 |  | First amendment dated August 5, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated herein by
reference to Exhibit No. 10.10 of Form 10-K filed March 30, 1995, File No. 33-77568).    
|      | 
|10.12 |  | Second amendment dated December 14, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated herein
by reference to Exhibit No. 10.12 of Form 10-K filed March 30, 1995, File No. 33-77568).
|      | 
|10.13 |  | Lease agreement for office space dated September 20, 1996, by and between Valley Bank, N.A. and Betty J. Burrows (incorporated herein by reference to Exhibit No. 10.13 of Form 10-KSB filed
March 27, 1997, File No. 33-77568).                                                       



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##### Table of Contents

|       |  |                                                                                                                                                                                                                                   
|------ |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|       | 
|*10.6  |  | Severance agreement dated February 9, 1998, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit No. 10.6 of Form 10-KSB filed March 30, 2000, File
No. 33-77568).                      
|       | 
|*10.7  |  | Employment agreement dated September 21, 2000, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit 10.2 of Form SB-2, filed September 27, 2000, and
Form SB-2/A filed October 25, 2000).
|       | 
|*10.14 |  | Valley Bank Supplemental Retirement Plan effective January 1, 2002 (incorporated herein by reference to Exhibit 10.14 of Form 10-QSB filed May 15, 2002, File No. 33-77568).                                                      
|       | 
|*10.15 |  | Employment agreement dated August 26, 2002, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit 10.15 of Form 10-QSB filed November 14, 2002, File
No. 33-77568).                      
|       | 
|11     |  | Statement re Computation of Earnings per Share (filed herewith as Note 5).                                                                                                                                                        
|       | 
|31.1   |  | Chief Executive Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                 
|       | 
|31.2   |  | Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                 
|       | 
|32.1   |  | Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                  
|       | 
|32.2   |  | Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                  

---

|* | Management contract or compensatory plan or agreement required to be filed as an Exhibit to this Form 10-QSB pursuant to Item 13(a).
|- | ------------------------------------------------------------------------------------------------------------------------------------



|(b) | Reports on Form 8-K filed during the quarter covered by this report:
|--- | --------------------------------------------------------------------



The Company filed two reports on Form 8-K during the quarter ended September 30, 2004. The report, dated July 23, 2004, reported the Companys
consolidated financial results for the quarter ended June 30, 2004. The report, dated September 27, 2004, reported the Companys intention to sell 275,000 shares of its authorized but unissued common stock in a private offering.



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##### Table of Contents

SIGNATURES



Pursuant to the requirements of the
Securities Exchange Act of 1934, the small business issuer has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                  |  |                             
|----------------- |  | ----------------------------
|                  |  | VALLEY FINANCIAL CORPORATION
|                  | 
|November 15, 2004 |  | /s/ Ellis L. Gutshall       
|Date              |  | Ellis L. Gutshall, President
|                  |  | and Chief Executive Officer 
|                  | 
|November 15, 2004 |  | /s/ A. Wayne Lewis          
|Date              |  | A. Wayne Lewis, Executive   
|                  |  | Vice President and Chief    
|                  |  | Financial Officer           



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##### Table of Contents

INDEX TO EXHIBITS



|               |  |                                                                                                                                                                                                                                                                                         |  |           
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                             |  | PageNumber
|3.1            |  | Articles of Incorporation (incorporated herein by reference to Exhibit No. 3.1 of Registration Statement No. 33-77568, on Form S-1, as amended).                                                                                                                                        |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|3.2            |  | Bylaws (incorporated herein by reference to Exhibit No. 3.2 of Registration Statement No. 33-77568, on Form S-1, as amended).                                                                                                                                                           |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|10.2           |  | Employment Agreement dated April 8, 1994, by and between the Company and A. Wayne Lewis (incorporated herein by reference to Exhibit No. 10.2 of Registration Statement No. 33-77568, on Form
S-1, as amended).                                                                         |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|10.3           |  | Severance Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.3 of Form 10-KSB filed March 27, 1997, File
No. 33-77568).                                                                            |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|10.4           |  | Stock Option Agreement dated December 19, 1996, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit No. 10.4 of Form 10-KSB filed March 27, 1997,
File No. 33-77568).                                                                         |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|10.5           |  | Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated herein by reference to Exhibit No. 10.5 of Registration
Statement No. 33-77568, on Form S-1, as amended).                                        |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|10.10          |  | First amendment dated August 5, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated herein by
reference to Exhibit No. 10.10 of Form 10-K filed March 30, 1995, File No. 33-77568).     |  |           
|               |  |                                                                                                                                                                                                                                                                                        
|10.12          |  | Second amendment dated December 14, 1994, to the Office Lease dated February 28, 1994, by and between First Federal Building, L.C. and Valley Financial Enterprises, L.C. (incorporated herein
by reference to Exhibit No. 10.12 of Form 10-K filed March 30, 1995, File No. 33-77568). |  |           



31



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##### Table of Contents

|      |  |                                                                                                                                                                                                                                    |  |   
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --
|      |  |                                                                                                                                                                                                                                   
|10.13 |  | Lease agreement for office space dated September 20, 1996, by and between Valley Bank, N.A. and Betty J. Burrows (incorporated herin by reference to Exhibit No. 10.13 of Form 10-KSB filed
March 27, 1997, File No. 33-77568).    |  |   
|      |  |                                                                                                                                                                                                                                   
|10.6  |  | Severance agreement dated February 9, 1998, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit 10.6 of Form 10-KSB filed March 30, 2000, File No.
33-77568).                           |  |   
|      |  |                                                                                                                                                                                                                                   
|10.7  |  | Employment agreement dated September 21, 2000, by and between the Company and Ellis L. Gutshall (incorporated herein by reference to Exhibit 10.2 of Form SB-2, filed September 27, 2000, and
Form SB-2/A filed October 25, 2000). |  |   
|      |  |                                                                                                                                                                                                                                   
|10.14 |  | Valley Bank Supplemental Retirement Plan effective January 1, 2002 (incorporated herein by reference to Exhibit 10.14 of Form 10-QSB filed May 15, 2002, File No. 33-77568).                                                       |  |   
|      |  |                                                                                                                                                                                                                                   
|10.15 |  | Employment agreement dated August 26, 2002, by and between the Company and J. Randall Woodson (incorporated herein by reference to Exhibit 10.15 of Form 10-QSB filed November 14, 2002, File
No. 33-77568).                       |  |   
|      |  |                                                                                                                                                                                                                                   
|11    |  | Statement re Computation of Earnings per Share (filed herewith as Note 5).                                                                                                                                                         |  |   
|      |  |                                                                                                                                                                                                                                   
|31.1  |  | Chief Executive Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                  |  | 33
|      |  |                                                                                                                                                                                                                                   
|31.2  |  | Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                  |  | 34
|      |  |                                                                                                                                                                                                                                   
|32.1  |  | Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                   |  | 35
|      |  |                                                                                                                                                                                                                                   
|32.2  |  | Chief Financial Officer Certification Pursuant to 18 U.S.C. Section 1350, as adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                   |  | 36



32