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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 June 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)



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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 August 12, 2004 there were 3,798,830 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

June 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                             |  | 27
|                              | 
|Part II.
OTHER INFORMATION    |  |        
|                              |  |         | 
|                              |  | Item 4. |  | Submission of Matters to a Vote of Security Holders |  | 28
|                              |  |         | 
|                              |  | Item 5. |  | Other Information                                   |  | 29
|                              |  |         | 
|                              |  | Item 6. |  | Exhibits and Reports on Form 8-K                    |  | 29
|                              | 
|SIGNATURES                    |  | 31     
|                              | 
|EXHIBIT INDEX                 |  | 32     
|                              | 
|CERTIFICATIONS                |  | 34     



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) June 302004 |         |   | December 31 2003 |  
|Assets                                                                                                                                          |  |                         |         |   |                  |   |         |  
|Cash and due from banks                                                                                                                         |  | $                       | 8,488   |   |                  | $ | 7,511   |  
|Interest-bearing deposits in other banks                                                                                                        |  |                         | 78      |   |                  |   | 713     |  
|Securities held to maturity (approximate market values of $22,481 at June 30, 2004 and $22,828 at December 31, 2003)                            |  |                         | 23,136  |   |                  |   | 22,986  |  
|Securities available for sale                                                                                                                   |  |                         | 48,233  |   |                  |   | 40,066  |  
|Restricted equity securities                                                                                                                    |  |                         | 3,143   |   |                  |   | 3,143   |  
|Loans:                                                                                                                                          |  |                         |         |   |                  |   |         |  
|Commercial and industrial loans                                                                                                                 |  |                         | 61,455  |   |                  |   | 53,141  |  
|Commercial real estate loans                                                                                                                    |  |                         | 102,253 |   |                  |   | 92,563  |  
|Real estate construction                                                                                                                        |  |                         | 20,552  |   |                  |   | 17,622  |  
|Residential real estate loans                                                                                                                   |  |                         | 35,570  |   |                  |   | 29,959  |  
|Loans to individuals                                                                                                                            |  |                         | 31,658  |   |                  |   | 29,318  |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Total loans                                                                                                                                     |  |                         | 251,488 |   |                  |   | 222,603 |  
|Less unearned income                                                                                                                            |  |                         | (3      | ) |                  |   | (5      | )
|Less allowance for loan losses                                                                                                                  |  |                         | (2,798  | ) |                  |   | (2,566  | )
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Net loans                                                                                                                                       |  |                         | 248,687 |   |                  |   | 220,032 |  
|Premises and equipment                                                                                                                          |  |                         | 6,166   |   |                  |   | 6,067   |  
|Bank owned life insurance                                                                                                                       |  |                         | 5,984   |   |                  |   | 5,835   |  
|Accrued interest receivable                                                                                                                     |  |                         | 1,304   |   |                  |   | 1,204   |  
|Other assets                                                                                                                                    |  |                         | 1,757   |   |                  |   | 1,452   |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Total assets                                                                                                                                    |  | $                       | 346,976 |   |                  | $ | 309,009 |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Liabilities and Shareholders Equity                                                                                                            |  |                         |         |   |                  |   |         |  
|Deposits:                                                                                                                                       |  |                         |         |   |                  |   |         |  
|Non-interest bearing demand deposits                                                                                                            |  | $                       | 43,469  |   |                  | $ | 36,668  |  
|Interest bearing demand deposits                                                                                                                |  |                         | 16,181  |   |                  |   | 16,602  |  
|Money market deposits                                                                                                                           |  |                         | 34,124  |   |                  |   | 29,217  |  
|Other savings deposits                                                                                                                          |  |                         | 4,444   |   |                  |   | 4,593   |  
|Certificates of deposits >$100,000                                                                                                              |  |                         | 39,152  |   |                  |   | 39,464  |  
|Other time deposits                                                                                                                             |  |                         | 115,642 |   |                  |   | 96,478  |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Total deposits                                                                                                                                  |  |                         | 253,012 |   |                  |   | 223,022 |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Short-term borrowings                                                                                                                           |  |                         | 15,000  |   |                  |   | 15,000  |  
|Federal funds purchased                                                                                                                         |  |                         | 8,203   |   |                  |   | 2,556   |  
|Securities sold under agreements to repurchase                                                                                                  |  |                         | 5,951   |   |                  |   | 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                                                                                                                        |  |                         | 834     |   |                  |   | 736     |  
|Other liabilities                                                                                                                               |  |                         | 271     |   |                  |   | 406     |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Total liabilities                                                                                                                               |  |                         | 324,271 |   |                  |   | 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 3,798,030 at June 30, 2004 and 3,665,502 at December 31,
2003. |  |                         | 13,138  |   |                  |   | 12,396  |  
|Accumulated retained earnings                                                                                                                   |  |                         | 10,046  |   |                  |   | 8,969   |  
|Accumulated other comprehensive income (loss)                                                                                                   |  |                         | (479    | ) |                  |   | 197     |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Total shareholders equity                                                                                                                      |  |                         | 22,705  |   |                  |   | 21,562  |  
|                                                                                                                                                |  |                         |         |   |                  |   |         |  
|Total liabilities and shareholders equity                                                                                                      |  | $                       | 346,976 |   |                  | $ | 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 PeriodJanuary 1, 2004 Through June 30,
2004 |       | For the PeriodJanuary 1, 2003 Through June 30,
2003
|Interest Income:                                                                                      |  |                                                     |       |                                                     |   |      
|Interest and fees on loans                                                                            |  | $                                                   | 6,845 |                                                     | $ | 6,374
|Interest on money market investments                                                                  |  |                                                     | 26    |                                                     |   | 40   
|Interest on securities  taxable                                                                      |  |                                                     | 1,077 |                                                     |   | 650  
|Interest on securities  nontaxable                                                                   |  |                                                     | 325   |                                                     |   | 305  
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Total interest income                                                                                 |  |                                                     | 8,273 |                                                     |   | 7,369
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Interest Expense:                                                                                     |  |                                                     |       |                                                     |   |      
|Interest on certificates of deposit > $100,000                                                        |  |                                                     | 501   |                                                     |   | 475  
|Interest on other deposits                                                                            |  |                                                     | 1,671 |                                                     |   | 1,450
|Interest on long-term borrowings                                                                      |  |                                                     | 786   |                                                     |   | 743  
|Interest on repurchase agreements                                                                     |  |                                                     | 21    |                                                     |   | 28   
|Interest on federal funds purchased                                                                   |  |                                                     | 12    |                                                     |   | 9    
|Interest on guaranteed preferred beneficial interests in the Companys junior subordinated debentures |  |                                                     | 86    |                                                     |   | 2    
|Interest on short-term borrowings                                                                     |  |                                                     | 92    |                                                     |   | 67   
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Total interest expense                                                                                |  |                                                     | 3,169 |                                                     |   | 2,774
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Net interest income                                                                                   |  |                                                     | 5,104 |                                                     |   | 4,595
|                                                                                                      |  |                                                    
|Provision for loan losses                                                                             |  |                                                     | 247   |                                                     |   | 356  
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Net interest income after provision for loan losses                                                   |  |                                                     | 4,857 |                                                     |   | 4,239
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Noninterest income:                                                                                   |  |                                                     |       |                                                     |   |      
|Service charges on deposit accounts                                                                   |  |                                                     | 370   |                                                     |   | 332  
|Income earned on bank owned life insurance                                                            |  |                                                     | 149   |                                                     |   | 132  
|Other income on real estate loans                                                                     |  |                                                     | 55    |                                                     |   | 110  
|Other fee income                                                                                      |  |                                                     | 69    |                                                     |   | 63   
|Realized gains on sales of securities available for sale                                              |  |                                                     | 17    |                                                     |   | 7    
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Total noninterest income                                                                              |  |                                                     | 660   |                                                     |   | 644  
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Noninterest expense:                                                                                  |  |                                                     |       |                                                     |   |      
|Compensation expense                                                                                  |  |                                                     | 2,016 |                                                     |   | 1,767
|Occupancy expense                                                                                     |  |                                                     | 228   |                                                     |   | 186  
|Data processing and equipment expense                                                                 |  |                                                     | 457   |                                                     |   | 354  
|Franchise tax expense                                                                                 |  |                                                     | 78    |                                                     |   |     
|Purchased tax credit expense                                                                          |  |                                                     | 25    |                                                     |   | 214  
|Deposit expenses                                                                                      |  |                                                     | 95    |                                                     |   | 76   
|Loan expenses                                                                                         |  |                                                     | 211   |                                                     |   | 156  
|Other expense                                                                                         |  |                                                     | 644   |                                                     |   | 501  
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Total noninterest expense                                                                             |  |                                                     | 3,754 |                                                     |   | 3,254
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Net income before taxes                                                                               |  |                                                     | 1,763 |                                                     |   | 1,629
|                                                                                                      |  |                                                    
|Provision for income taxes                                                                            |  |                                                     | 459   |                                                     |   | 315  
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Net income                                                                                            |  | $                                                   | 1,304 |                                                     | $ | 1,314
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Basic earnings per share                                                                              |  | $                                                   | 0.35  |                                                     | $ | 0.36 
|                                                                                                      |  |                                                     |       |                                                     |   |      
|Diluted earnings per share                                                                            |  | $                                                   | 0.33  |                                                     | $ | 0.34 
|                                                                                                      |  |                                                     |       |                                                     |   |      



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 PeriodApril 1, 2004Through June 30, 2004 |       | For the PeriodApril 1, 2003Through June 30, 2003
|Interest Income:                                                                                      |  |                                                  |       |                                                  |   |      
|Interest and fees on loans                                                                            |  | $                                                | 3,525 |                                                  | $ | 3,207
|Interest on money market investments                                                                  |  |                                                  | 16    |                                                  |   | 30   
|Interest on securities  taxable                                                                      |  |                                                  | 551   |                                                  |   | 342  
|Interest on securities  nontaxable                                                                   |  |                                                  | 157   |                                                  |   | 156  
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Total interest income                                                                                 |  |                                                  | 4,249 |                                                  |   | 3,735
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Interest Expense:                                                                                     |  |                                                  |       |                                                  |   |      
|Interest on certificates of deposit > $100,000                                                        |  |                                                  | 250   |                                                  |   | 243  
|Interest on other deposits                                                                            |  |                                                  | 865   |                                                  |   | 760  
|Interest on long-term borrowings                                                                      |  |                                                  | 393   |                                                  |   | 393  
|Interest on repurchase agreements                                                                     |  |                                                  | 11    |                                                  |   | 14   
|Interest on federal funds purchased                                                                   |  |                                                  | 5     |                                                  |   |     
|Interest on guaranteed preferred beneficial interests in the Companys junior subordinated debentures |  |                                                  | 43    |                                                  |   | 2    
|Interest on short-term borrowings                                                                     |  |                                                  | 46    |                                                  |   | 32   
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Total interest expense                                                                                |  |                                                  | 1,613 |                                                  |   | 1,444
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Net interest income                                                                                   |  |                                                  | 2,636 |                                                  |   | 2,291
|                                                                                                      |  |                                                 
|Provision for loan losses                                                                             |  |                                                  | 149   |                                                  |   | 98   
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Net interest income after provision for loan losses                                                   |  |                                                  | 2,487 |                                                  |   | 2,193
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Noninterest income:                                                                                   |  |                                                  |       |                                                  |   |      
|Service charges on deposit accounts                                                                   |  |                                                  | 187   |                                                  |   | 178  
|Income earned on bank owned life insurance                                                            |  |                                                  | 77    |                                                  |   | 69   
|Other income on real estate loans                                                                     |  |                                                  | 31    |                                                  |   | 57   
|Other fee income                                                                                      |  |                                                  | 32    |                                                  |   | 37   
|Realized gains on sales of securities available for sale                                              |  |                                                  | 13    |                                                  |   |     
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Total noninterest income                                                                              |  |                                                  | 340   |                                                  |   | 341  
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Noninterest expense:                                                                                  |  |                                                  |       |                                                  |   |      
|Compensation expense                                                                                  |  |                                                  | 1,028 |                                                  |   | 887  
|Occupancy expense                                                                                     |  |                                                  | 112   |                                                  |   | 91   
|Data processing and equipment expense                                                                 |  |                                                  | 232   |                                                  |   | 183  
|Franchise tax expense                                                                                 |  |                                                  | 47    |                                                  |   |     
|Purchased tax credit expense                                                                          |  |                                                  |      |                                                  |   | 35   
|Deposit expenses                                                                                      |  |                                                  | 49    |                                                  |   | 41   
|Loan expenses                                                                                         |  |                                                  | 99    |                                                  |   | 75   
|Other expense                                                                                         |  |                                                  | 349   |                                                  |   | 263  
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Total noninterest expense                                                                             |  |                                                  | 1,916 |                                                  |   | 1,575
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Net income before taxes                                                                               |  |                                                  | 911   |                                                  |   | 959  
|                                                                                                      |  |                                                 
|Provision for income taxes                                                                            |  |                                                  | 237   |                                                  |   | 227  
|                                                                                                      |  |                                                  |       |                                                  |   |      
|Net income                                                                                            |  | $                                                | 674   |                                                  | $ | 732  
|                                                                                                      |  |                                                  |       |                                                  |   |      
|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 PeriodJanuary 1, 2004 Through June 30,
2004 |         |   | For the PeriodJanuary 1, 2003 Through June 30,
2003 |  
|Cash Flows From Operating Activities:                                                                               |  |                                                     |         |   |                                                     |   |         |  
|Net income                                                                                                          |  | $                                                   | 1,304   |   |                                                     | $ | 1,314   |  
|Adjustments to reconcile net income to net cash provided by operating activities:                                   |  |                                                     |         |   |                                                     |   |         |  
|Provision for loan losses                                                                                           |  |                                                     | 247     |   |                                                     |   | 356     |  
|Depreciation and amortization                                                                                       |  |                                                     | 309     |   |                                                     |   | 227     |  
|Tax benefit from exercise of stock options                                                                          |  |                                                     | 287     |   |                                                     |   |        |  
|Net gains on sale of securities                                                                                     |  |                                                     | (17     | ) |                                                     |   | (7      | )
|Net losses on sales of foreclosed properties                                                                        |  |                                                     | 8       |   |                                                     |   | 6       |  
|Net losses on disposals of fixed assets                                                                             |  |                                                     |        |   |                                                     |   | 5       |  
|Amortization (accretion) of premiums/discounts                                                                      |  |                                                     | 146     |   |                                                     |   | 71      |  
|Decrease in unearned fees                                                                                           |  |                                                     | (2      | ) |                                                     |   | (3      | )
|Increase in accrued interest receivable                                                                             |  |                                                     | (100    | ) |                                                     |   | (29     | )
|Increase in other assets                                                                                            |  |                                                     | (11     | ) |                                                     |   | (456    | )
|Increase in value of life insurance contracts                                                                       |  |                                                     | (149    | ) |                                                     |   | (130    | )
|Increase (decrease) in accrued interest payable                                                                     |  |                                                     | 98      |   |                                                     |   | (290    | )
|Decrease in other liabilities                                                                                       |  |                                                     | (135    | ) |                                                     |   | (371    | )
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Net cash provided by operating activities                                                                           |  |                                                     | 1,985   |   |                                                     |   | 693     |  
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Cash Flows From Investing Activities:                                                                               |  |                                                     |         |   |                                                     |   |         |  
|Increase (decrease) in money market investments                                                                     |  |                                                     | 635     |   |                                                     |   | (1,027  | )
|Purchases of premises and equipment                                                                                 |  |                                                     | (359    | ) |                                                     |   | (455    | )
|Purchases of securities available for sale                                                                          |  |                                                     | (18,868 | ) |                                                     |   | (15,816 | )
|Purchases of securities held to maturity                                                                            |  |                                                     | (2,368  | ) |                                                     |   | (10,141 | )
|Purchases of restricted equity securities                                                                           |  |                                                     |        |   |                                                     |   | (350    | )
|Principal repays/sales/calls of securities available for sale                                                       |  |                                                     | 9,631   |   |                                                     |   | 4,926   |  
|Principal repays/calls of securities held to maturity                                                               |  |                                                     | 2,136   |   |                                                     |   | 6,696   |  
|Proceeds from sale of fixed assets                                                                                  |  |                                                     | 3       |   |                                                     |   |        |  
|Investment in life insurance contracts                                                                              |  |                                                     |        |   |                                                     |   | (1,200  | )
|Proceeds from sale of foreclosed properties                                                                         |  |                                                     | 276     |   |                                                     |   | 286     |  
|Capitalized foreclosed property expense                                                                             |  |                                                     |        |   |                                                     |   | (29     | )
|Increase in loans                                                                                                   |  |                                                     | (29,183 | ) |                                                     |   | (17,266 | )
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Net cash used in investing activities                                                                               |  |                                                     | (38,097 | ) |                                                     |   | (34,376 | )
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Cash Flows From Financing Activities:                                                                               |  |                                                     |         |   |                                                     |   |         |  
|Increase (decrease) in time deposits greater than $100,000                                                          |  |                                                     | (312    | ) |                                                     |   | 3,247   |  
|Increase in other time deposits                                                                                     |  |                                                     | 19,164  |   |                                                     |   | 11,482  |  
|Increase in other deposits                                                                                          |  |                                                     | 11,138  |   |                                                     |   | 10,754  |  
|Increase in short-term borrowings                                                                                   |  |                                                     | 5,647   |   |                                                     |   |        |  
|Increase in securities sold under agreements to repurchase                                                          |  |                                                     | 1,224   |   |                                                     |   | 455     |  
|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                                                                              |  |                                                     | 455     |   |                                                     |   | 29      |  
|Cash dividends declared                                                                                             |  |                                                     | (227    | ) |                                                     |   |        |  
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Net cash provided by financing activities                                                                           |  |                                                     | 37,089  |   |                                                     |   | 36,967  |  
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Net Increase in Cash and Due From Banks                                                                             |  |                                                     | 977     |   |                                                     |   | 3,284   |  
|Cash and Due From Banks at Beginning of Period                                                                      |  |                                                     | 7,511   |   |                                                     |   | 8,163   |  
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  
|Cash and Due From Banks at End of Period                                                                            |  | $                                                   | 8,488   |   |                                                     | $ | 11,447  |  
|                                                                                                                    |  |                                                     |         |   |                                                     |   |         |  



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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 June 30, 2004 |       | For the PeriodJanuary 1, 2003 Through June 30,
2003
|Supplemental disclosure of cash flow information: |  |                                                      |       |                                                     |   |      
|Cash paid during the period for interest          |  | $                                                    | 3,071 |                                                     | $ | 3,064
|                                                  |  |                                                      |       |                                                     |   |      
|Cash paid during the period for taxes             |  | $                                                    | 523   |                                                     | $ | 479  
|                                                  |  |                                                      |       |                                                     |   |      
|Noncash financing and investing activities:       |  |                                                      |       |                                                     |   |      
|Transfer of loans to foreclosed property          |  | $                                                    | 283   |                                                     | $ | 264  
|                                                  |  |                                                      |       |                                                     |   |      



See accompanying notes to consolidated
financial statements.



7



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##### Table of Contents

VALLEY FINANCIAL CORPORATION



Notes
to Consolidated Financial Statements

June 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 June 30, 2004 was $781. As a condition of our correspondent bank agreement, the Bank is also required to
maintain a target balance. The target balance as of June 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 June 30, 2004 are shown in the tables below. As of June 30, 2004 investments (including both available for sale and held to maturity) and restricted equity securities with amortized costs and fair values of $36,625 and $35,899,
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 June 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)



|                                    |  |                |        |                 |   |                  |  |   |                        |   |  |   |       
|----------------------------------- |  | -------------- | ------ | --------------- | - | ---------------- |  | - | ---------------------- | - |  | - | ------
|                                    |  | AmortizedCosts |        | UnrealizedGains |   | UnrealizedLosses |  |   | ApproximateFair Values
|U.S. Government agencies            |  | $              | 10,436 |                 |   | 31               |  |   | (125                   | ) |  | $ | 10,342
|                                    |  |                |        |                
|Mortgage-backed securities          |  |                | 7,694  |                 |   | 7                |  |   | (200                   | ) |  |   | 7,501 
|                                    |  |                |        |                
|Collateralized mortgage obligations |  |                | 20,691 |                 |   | 39               |  |   | (555                   | ) |  |   | 20,175
|                                    |  |                |        |                
|States and political subdivisions   |  |                | 9,937  |                 |   | 174              |  |   | (94                    | ) |  |   | 10,017
|                                    |  |                |        |                
|Corporate debt securities           |  |                | 200    |                 |   | 1                |  |   | (3                     | ) |  |   | 198   
|                                    |  |                |        |                 |   |                  |  |   |                        |   |  |   |       
|Total securities available for sale |  | $              | 48,958 |                 | $ | 252              |  | $ | (977                   | ) |  | $ | 48,233
|                                    |  |                |        |                 |   |                  |  |   |                        |   |  |   |       



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



Held to Maturity Investment Portfolio  Category Distribution

(dollars in thousands)



|                                    |  |                |        |                 |   |                  |  |   |                        |   |  |   |       
|----------------------------------- |  | -------------- | ------ | --------------- | - | ---------------- |  | - | ---------------------- | - |  | - | ------
|                                    |  | AmortizedCosts |        | UnrealizedGains |   | UnrealizedLosses |  |   | ApproximateFair Values
|U.S. Treasury                       |  | $              | 199    |                 | $ |                 |  | $ | (1                     | ) |  | $ | 198   
|                                    |  |                |        |                
|U.S. Government agencies            |  |                | 9,926  |                 |   |                 |  |   | (307                   | ) |  |   | 9,619 
|                                    |  |                |        |                
|Mortgage-backed securities          |  |                | 4,777  |                 |   |                 |  |   | (63                    | ) |  |   | 4,714 
|                                    |  |                |        |                
|Collateralized mortgage obligations |  |                | 972    |                 |   |                 |  |   | (46                    | ) |  |   | 926   
|                                    |  |                |        |                
|States and political subdivisions   |  |                | 7,262  |                 |   |                 |  |   | (238                   | ) |  |   | 7,024 
|                                    |  |                |        |                 |   |                  |  |   |                        |   |  |   |       
|Total securities held to maturity   |  | $              | 23,136 |                 | $ |                 |  | $ | (655                   | ) |  | $ | 22,481
|                                    |  |                |        |                 |   |                  |  |   |                        |   |  |   |       



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



The following table summarizes the loan loss experience for the six-month periods ended June 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         |  |      | 247   |   |      |   | 356   |  
|                                  |  |     
|Recoveries  Loans to individuals |  |      |      |   |      |   | 1     |  
|                                  |  |     
|Charged off loans                 |  |      |       |   |      |   |       |  
|                                  |  |     
|Commercial                        |  |      |      |   |      |   |      |  
|                                  |  |     
|Credit Cards                      |  |      | (1    | ) |      |   |      |  
|                                  |  |     
|Loans to individuals              |  |      | (14   | ) |      |   | (11   | )
|                                  |  |      |       |   |      |   |       |  
|Balance at June 30                |  | $    | 2,798 |   |      | $ | 2,360 |  
|                                  |  |      |       |   |      |   |       |  



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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  
|Six months ending June 30:   |  |           |  |          
|                             |  |          
|2004                         |  | 3,690,755 |  | 3,967,175
|                             |  |           |  |          
|2003                         |  | 3,660,460 |  | 3,871,698
|                             |  |           |  |          
|                             |  |          
|                             |  | Basic     |  | Diluted  
|Three months ending June 30: |  |           |  |          
|                             |  |          
|2004                         |  | 3,715,364 |  | 3,981,700
|                             |  |           |  |          
|2003                         |  | 3,662,952 |  | 3,892,662
|                             |  |           |  |          



The
Company paid its first cash dividend of $.06 per share on July 1, 2004 to shareholders of record June 1, 2004.



| | (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 (losses) 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
(losses) on available-for-sale securities, an item of other comprehensive income (loss). For the six months ended June 30, 2004 and 2003, total comprehensive income was $629 and $1,547, respectively. For the three months ended June 30, 2004 and
2003, total comprehensive income (loss) was $(224) and $999, 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 six and three month periods ended June 30, 2004 and 2003.



|                                                                   |  |                                          |        |   |                                          |   |      |  
|------------------------------------------------------------------ |  | ---------------------------------------- | ------ | - | ---------------------------------------- | - | ---- | -
|                                                                   |  | For the Six Months Ended June 30, 2004   |        |   | For the Six Months Ended June 30, 2003   |  
|Net unrealized gains(losses) on securities available for sale:     |  |                                          |        |   |                                          |   |      |  
|Net unrealized holding gains during the year                       |  | $                                        | (1,006 | ) |                                          | $ | 360  |  
|Less reclassification adjustments for gains included in net income |  |                                          | (11    | ) |                                          |   | (5   | )
|Income tax(expense) benefit                                        |  |                                          | 342    |   |                                          |   | (122 | )
|                                                                   |  |                                          |        |   |                                          |   |      |  
|Other comprehensive income(loss), net of income taxes              |  | $                                        | (675   | ) |                                          | $ | 233  |  
|                                                                   |  |                                          |        |   |                                          |   |      |  
|                                                                   |  |                                         
|                                                                   |  | For the Three Months Ended June 30, 2004 |        |   | For the Three Months Ended June 30, 2003 |  
|Net unrealized gains(losses) on securities available for sale:     |  |                                          |        |   |                                          |   |      |  
|Net unrealized holding gains during the quarter                    |  | $                                        | (1,347 | ) |                                          | $ | 405  |  
|Less reclassification adjustments for gains included in net income |  |                                          | (9     | ) |                                          |   |     |  
|Income tax (expense) benefit                                       |  |                                          | 458    |   |                                          |   | (138 | )
|                                                                   |  |                                          |        |   |                                          |   |      |  
|Other comprehensive income, net of income taxes                    |  | $                                        | (898   | ) |                                          | $ | 267  |  
|                                                                   |  |                                          |        |   |                                          |   |      |  



| | (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 June 30, 2004 outstanding commitments to extend credit were $80,058 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 June 30, 2004 aggregate loans to directors, executive officers, and principal shareholders totaled $9,933.



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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 June 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 June 30, 2004.



LONG-TERM FEDERAL HOME LOAN BANK ADVANCES



|                |  |                   |  |                   |  |      |   |  |                      |  |                              
|--------------- |  | ----------------- |  | ----------------- |  | ---- | - |  | -------------------- |  | -----------------------------
|Advance Balance |  | Advance Date      |  | Maturity Date     |  | Rate |   |  | InterestPaymentDates |  | 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
June 26, 2003, at which time the Trust issued $4,000 in aggregate liquidation amount of $1 par value preferred capital trust securities which mature June 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 June 26, 2008. The principal assets of the Trust are $4,124 of the Companys junior subordinated debentures which mature on June 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 June 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.



12



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##### Table of Contents

|(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 236,145 shares granted to officers and key employees currently outstanding as of June 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 June 30, 2004. Information
related to pro forma net income and per share (adjusted for stock splits) amounts for the periods presented is as follows:



|                                                                               |  |                          |       |      |   |      
|------------------------------------------------------------------------------ |  | ------------------------ | ----- | ---- | - | -----
|                                                                               |  | Six Months EndedJune 30,
|                                                                               |  | 2004                     |       | 2003
|Compensation cost recognized in income for all stock-based compensation awards |  | $                        |      |      | $ |     
|                                                                               |  |                         
|Pro forma net income, based on SFAS No. 123                                    |  | $                        | 1,274 |      | $ | 1,274
|                                                                               |  |                         
|Pro forma basic net income per share, based on SFAS No. 123                    |  | $                        | .35   |      | $ | .35  
|                                                                               |  |                         
|Pro forma diluted net income per share, based on SFAS No. 123                  |  | $                        | .32   |      | $ | .33  
|                                                                               | 
|                                                                               |  | Quarter Ended June 30,  
|                                                                               |  | 2004                     |       | 2003
|                                                                               |  |                         
|Compensation cost recognized in income for all stock-based compensation awards |  | $                        |      |      | $ |     
|                                                                               |  |                         
|Pro forma net income, based on SFAS No. 123                                    |  | $                        | 659   |      | $ | 712  
|                                                                               |  |                         
|Pro forma basic net income per share, based on SFAS No. 123                    |  | $                        | .18   |      | $ | .19  
|                                                                               |  |                         
|Pro forma diluted net income per share, based on SFAS No. 123                  |  | $                        | .17   |      | $ | .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 six months and the quarters ended June 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.



Total assets at June 30, 2004 were $347.0 million, up 12.3% from $309.0
million at December 31, 2003. The principal components of the Companys assets at the end of the period were $51.4 million in securities available-for-sale, including restricted equity securities, $23.1 million in securities held to maturity,
and $251.5 million in gross loans.



Total liabilities at June
30, 2004 were $324.3 million, up 12.8% from $287.4 million at December 31, 2003 with the increase represented by $30.0 million growth in deposits, $1.2 million growth in securities sold under agreements to repurchase and a $5.6 million increase in
overnight borrowings.



Total shareholders equity at June
30, 2004 was $22.7 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, $565,000 in proceeds from the exercise of stock options
and $287,000 deferred tax benefit from the exercise of stock options, all increased by accumulated retained earnings of $10.0 million and reduced by $479,000 of unrealized depreciation on securities available-for-sale, net of related deferred tax
liability. Total shareholders equity was $22.7 million at June 30, 2004 compared with $21.6 million at December 31, 2003, an increase of $1.1 million or 5.3%. Exclusive of unrealized gains (losses) on investment securities, shareholders
equity was $23.2 million at June 30, 2004 and $21.4 million at December 31, 2003.



The Company had net income of $1,304 for the six months ended June 30, 2004, a decrease of $10 or 0.8% from the six months ended June 30, 2003. Net income for the three months ended June 30, 2004



14



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##### Table of Contents

was $674, a 7.9% decrease from the $732 recorded for the second quarter 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 0.80% for the six months ended June 30, 2004 compared to 1.00% for the same period in 2003. ROA for the second quarter of 2004 was 0.81% versus 1.07% for the second quarter of 2003. Return on average equity (ROE)
was 11.86% for the six months ended June 30, 2004 compared to 13.62% for the same period in 2003. ROE for the second quarter of 2004 was 12.03% as compared to 14.84% for the second 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 $5.1 million for the six months ended June 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 six months of 2004 increased 11.1% from $4.6 million for the same period in 2003.
The net interest margin on a fully taxable equivalent (FTE) basis was 3.43% for the first six months of 2004, a decrease of 47 basis points from the 3.90% 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 2.10% for the six months ended June 30, 2004, down 21 basis points from the 2.31% reported for the first six months of 2003. The Banks yield on earning assets was
5.49% for the six months ended June 30, 2004, down 68 basis points from the 6.17% reported for the six months ended June 30, 2003. For the three months ended June 30, 2004 net interest income was $2.6 million, an increase of 15.1% from the $2.3
million reported for the three months ended June 30, 2003. The FTE net interest margin was 3.44% and 3.70% for the three month periods ended June 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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Noninterest Income



Noninterest income for the six months ended June 30, 2004 was $660, an increase of $16 or 2.5% over the $644 reported for the same period one year
earlier. The largest components of the increase are service charges on deposit accounts in the amount of $38 and a $17 increase in income on bank-owned life insurance, offset by a $55 decline in other income on real estate loans. Securities gains
and losses totaled $17 during the first six months of 2004 as compared to $7 for the first six months of 2003. For the three months ended June 30, 2004 noninterest income was $340, a decrease of $1 or 0.3% from the $341 reported for the second
quarter of 2003. The reasons for the decline in noninterest income for the second quarter are the same as for the modest increase for the first half of 2004. Securities gains of $13 and $0 are included in the total noninterest income totals for the
quarters ended June 30, 2004 and 2003, respectively. 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 six months of 2004 was $3.8 million, an increase of $500 or 15.4% over the $3.3 million reported for the same
period in 2003. Compensation expense was the largest contributor to the increase in the amount of $249. The second largest contributor to the increase was data processing and equipment expense in the amount of $103. 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 $78 in the first half 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 six months ended June 30, 2004. Substantially all major categories of noninterest expense increased in the first six months due to growth
and expansion. Noninterest expense for the quarter ended June 30, 2004 was $1.9 million, an increase of $341 or 21.7% over the $1.6 million reported for the second quarter of 2003. Substantially all major categories of noninterest expense increased
in the second 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 $459 and $315 at an effective tax rate of 26.0% and 19.3% was
recognized for the six months ended June 30, 2004 and June 30, 2003, respectively. The provision for income taxes for the second quarter of 2004 and 2003 was $237 and $227 at an effective tax rate of 26.0% and 23.7%, 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 $214 during the first six 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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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 June 30, 2004 were $74.5 million, an increase of $8.3 million or 12.6% from their level of $66.2 million on December 31, 2003. The increase is primarily due to
purchases in the amount of $21.1 million, offset by principal repayments, sale proceeds, and called proceeds in the amounts of $5.3 million, $5.5 million and $1.0 million, respectively. An increase in unrealized losses on securities in the available
for sale portfolio, which is carried at approximate fair market value, offset a portion of the increase. See Note 3 to the Consolidated Financial Statements.



Loan Portfolio



The Companys total loans were $251.5 million at June 30, 2004, an increase of $28.9 million or 13.0% 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 77.8% at June 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. Commercial and construction loans and home
equity lines of credit in the loan portfolio are primarily variable rate loans and have little interest rate risk.



The following table summarizes the loan portfolio by category as of the six-month periods ended June 30, 2004 and 2003 and the year ended December 31,
2003.



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##### Table of Contents

Loan Portfolio Summary

(dollars in thousands)



|                          |  |              |         |                   |   |              |  |   |        
|------------------------- |  | ------------ | ------- | ----------------- | - | ------------ |  | - | -------
|                          |  | June 30,2004 |         | December 31, 2003 |   | June 30,2003
|Commercial and industrial |  | $            | 61,455  |                   | $ | 53,141       |  | $ | 45,006 
|Commercial real estate    |  |              | 102,253 |                   |   | 92,563       |  |   | 81,379 
|Real estate construction  |  |              | 20,552  |                   |   | 17,622       |  |   | 20,241 
|Residential real estate   |  |              | 35,570  |                   |   | 29,959       |  |   | 27,960 
|Loans to individuals      |  |              | 31,658  |                   |   | 29,318       |  |   | 28,067 
|                          |  |              |         |                   |   |              |  |   |        
|Total loans               |  | $            | 251,488 |                   | $ | 222,603      |  | $ | 202,653
|                          |  |              |         |                   |   |              |  |   |        



Loan Category Analysis



Commercial Loans. Commercial and industrial loans
accounted for 24.4% of the loan portfolio as of June 30, 2004 and stood at $61.5 million versus $53.1 million six 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 40.7% of total loans at June 30, 2004. Outstanding loans in this category equaled $102.3 million and $92.6
million at June 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. Outstanding loans in this
category totaled $20.6 million (8.2% of total loans) at June 30, 2004 as compared to $17.6 million at December 31, 2003.



Residential Real Estate Loans. Residential real estate loans are secured by deeds of trust on 1-4 family residential properties. This category had
$35.6 million in loans (14.1% of total loans) at June 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 $31.7 million
(12.6% of total loans) at June 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 $247 was provided during the six months
ended June 30, 2004, a decrease of $109 or 30.6% 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 $2.8 million as of June 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 $120 in specific reserves is included in the balance of the allowance for loan
losses as of June 30, 2004. A total of $137 in specific reserves is included in the balance of the allowance for loan losses as of June 30, 2003. For the three months ended June 30, 2004 a provision for loan losses of $149 was made versus $98 during
the same period in 2003, a 52.0% increase of $51. 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 $438, $1,390 and $218, respectively for the six month period ended June 30, 2004, the year ended
December 31, 2003 and the six-month period ended June 30, 2003. The loan loss allowance related to impaired loans was $120, $30 and $137, respectively for the above-referenced time periods. To cover potential declines in the value of foreclosed
property, $0 was included in the loan loss allowance at June 30, 2004, $0 at December 31, 2003 and $40 at June 30, 2003. 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 June 30, 2004, December 31, 2003 and June 30, 2003 are presented in the following table.



Nonperforming Assets

(dollars in thousands)



|                                             |  |              |     |                   |   |              |  |   |    
|-------------------------------------------- |  | ------------ | --- | ----------------- | - | ------------ |  | - | ---
|                                             |  | June 30,2004 |     | December 31, 2003 |   | June 30,2003
|Nonaccrual loans                             |  | $            | 396 |                   | $ | 1,191        |  | $ | 217
|Loans past due 90 days or more               |  |              | 42  |                   |   |             |  |   | 1  
|Restructured loans                           |  |              |    |                   |   | 151          |  |   |   
|                                             |  |              |     |                   |   |              |  |   |    
|Total nonperforming loans                    |  |              | 438 |                   |   | 1,342        |  |   | 218
|                                             |  |              |     |                   |   |              |  |   |    
|Foreclosed, repossessed and idled properties |  |              |    |                   |   |             |  |   | 197
|                                             |  |              |     |                   |   |              |  |   |    
|Total nonperforming assets                   |  | $            | 438 |                   | $ | 1,342        |  | $ | 415
|                                             |  |              |     |                   |   |              |  |   |    



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If nonaccrual loans had performed in accordance with their original terms, additional interest income in
the amount of $22, $18 and $7, respectively would have been recorded for the six-month period ended June 30, 2004, the year ended December 31, 2003 and the six-month period ended June 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 $6.0 million at June 30, 2004, an increase of $149 over the $5.8 million reported as of December 31, 2003.



Other assets were $1.8 million at June 30, 2004, an increase of $305,000 over the $1.5 million reported as of December 31,
2003.



Deposits



As of June 30, 2004 total deposits were $253.0 million, an increase of $30.0
million or 13.4% from their level of $223.0 million at December 31, 2003. Certificates of deposit increased by $18.9 million to a total of $154.8 million (61.2% of total deposits) at June 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 $4.9 million, respectively, while interest bearing demand deposits declined $421 and savings deposits
declined $149. 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 June
30, 2004 were $13.6 million, representing 8.8% of total CDs and 5.2% of total deposits.



At June 30, 2004 noninterest-bearing demand deposits were $43.5 million or 17.2% 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 $98.2 million or 38.8% of total deposits at June 30, 2004 compared with $87.1 million or 39.1% of total deposits at
December 31, 2003. Total interest bearing deposits stood at $209.5 million at June 30, 2004, an increase of $23.2 million or 12.4% 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 $1.2
million from its level of $4.7 million at December 31, 2003 to a total of $6.0 million as of June 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 June 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 June 30, 2004 $13.2 million in overnight borrowings, up $5.6 million or 74.7% from their level of $7.6 million at December 31, 2003. The increase in overnight borrowings at June 30, 2004 was primarily
attributable to exceptionally strong loan growth in the month of June, and was subsequently offset by deposit growth. 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 June 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 4.68625%, 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 June 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 $1.1 million during the first
six months of 2004. The increase is attributable to net income for the first six months of $1,304 and $743 in proceeds from the exercise of stock options, partially offset by $227 in cash dividends declared and a $676 decrease in accumulated other
comprehensive income. Exclusive of unrealized gains (losses) on investment securities, shareholders equity was $23.2 million at June 30, 2004 and $21.4 million at December 31, 2003.



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



Capital Ratios



|         |  |         |   |  |          |   |  |         |  
|-------- |  | ------- | - |  | -------- | - |  | ------- | -
|Ratio    |  | 6/30/04 |   |  | 12/31/03 |   |  | 6/30/03 |  
|Tier 1   |  | 9.7     | % |  | 10.3     | % |  | 10.7    | %
|         |  |         |  
|Total    |  | 10.7    | % |  | 11.3     | % |  | 11.8    | %
|         |  |         |  
|Leverage |  | 8.1     | % |  | 8.4      | % |  | 8.7     | %



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 21.2% at June 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 no federal funds sold at either June 30, 2004 or December 31, 2003. During the first six months of 2004, deposit growth in the
amount of $30.0 million surpassed the $28.9 million loan growth experienced. The excess $1.1 million coupled with a $5.6 million increase in federal funds purchased was used to fund investment purchases in excess of principal paydowns, sales and
calls proceeds of approximately $9.5 million. The increase in securities sold under agreements to repurchase in the amount of $1.2 million alleviated somewhat the need to increase federal funds purchased during the period.



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



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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.



Recent and Future Accounting Considerations



In May 2003 the Financial Accounting Standards Board (FASB) issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which establishes
standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This Statement dictates certain instruments be classified as liabilities such as 1) a financial instrument issued
in the form of shares that is mandatorily redeemable  that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date or upon an event that is certain to occur, 2) a
financial instrument, other than an outstanding share, that, at inception, embodies an obligation to repurchase the issuers equity shares, or is indexed to such an obligation, and that requires or may require the issuer to settle the
obligation by transferring assets, and 3) a financial instrument that embodies an unconditional obligation, or a financial instrument other than an outstanding share that embodies a conditional obligation, that the issuer must or may settle by
issuing a variable number of its equity shares. This Statement does not apply to features that are embedded in a financial instrument that is not a derivative in its entirety. It also does not affect the classification or measurement of convertible
bonds, puttable stock, or other outstanding shares that are conditionally redeemable. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created
before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. Restatement is not permitted.



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In April 2003 the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment
of Statement 133 on Derivative Instruments and Hedging Activities, which amends FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities to amend and clarify financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in other contracts. This Statement improves financial reporting by requiring that contracts with comparable characteristics be accounted for in a similar manner. This
Statement more clearly defines under what circumstances a contract meets the characteristic of a derivative and clarifies when a derivative contains a financing component. The changes in this Statement will result in more consistent reporting of
contracts as either derivatives or hybrid instruments. The provisions of this Statement are effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The provisions of this
Statement that relate to Statement 133 Implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates.



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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.



The Company held its 2004 Annual Meeting of Shareholders on April 28, 2004, at which meeting four Class A directors were re-elected to new three-year terms. The following table indicates the total votes in favor of,
and withheld from voting on, the re-election of each nominee, and provides certain information with respect to those directors not standing for re-election whose term of office continued past the 2003 Annual Meeting of Shareholders:



|                      |  |                |  |                   |  |               
|--------------------- |  | -------------- |  | ----------------- |  | --------------
|DIRECTOR NAME         |  | TERM OF OFFICE |  | AFFIRMATIVE VOTES |  | VOTES WITHHELD
|Class A Directors     |  |                |  |                   |  |               
|Eddie F. Hearp        |  | 2004-2007      |  | 1,501,770         |  | 787           
|Anna L. Lawson        |  | 2004-2007      |  | 1,501,613         |  | 944           
|John W. Starr, M.D.   |  | 2004-2007      |  | 1,501,770         |  | 787           
|Michael E. Warner     |  | 2004-2007      |  | 1,501,770         |  | 787           
|Class B Directors     |  |                |  |                   |  |               
|Abney S. Boxley, III  |  | 2002-2005      |  |                   |  |               
|William D. Elliot     |  | 2002-2005      |  |                   |  |               
|Barbara B. Lemon      |  | 2002-2005      |  |                   |  |               
|Ward W. Stevens, M.D. |  | 2002-2005      |  |                   |  |               
|Class C Directors     |  |                |  |                   |  |               
|Ellis L. Gutshall     |  | 2003-2006      |  |                   |  |               
|Mason Haynesworth     |  | 2003-2006      |  |                   |  |               
|A. Wayne Lewis        |  | 2003-2006      |  |                   |  |               
|George W. Logan       |  | 2003-2006      |  |                   |  |               



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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 June 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 one report on Form 8-K during the quarter ended June 30, 2004. The report, dated April 29, 2004, reported the Companys
consolidated financial results for the quarter ended March 31, 2004.



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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         
|                | 
|August 13, 2004 |  | /s/ Ellis L. Gutshall                
|Date            |  | Ellis L. Gutshall,                   
|                |  | President and Chief Executive Officer
|                | 
|August 13, 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                                                                                                                                                                                                                                                                             |  | Page Number
|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). |  |            



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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).                                                                                                                  |  | 
|      |  |                                                                                                                                                                                                                                   
|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).                                                                   |  | 



33