SUMMIT FINANCIAL CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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 000-19235

SUMMIT FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

SOUTH CAROLINA

(State or other jurisdiction

of incorporation or organization)

57-0892056

(I.R.S. Employer

Identification No.)

Post Office Box 1087

937 North Pleasantburg Drive

Greenville, South Carolina 29602

(Address, including zip code, of principal executive offices)

(864) 242-2265

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES o NO x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of July 28, 2004, 4,453,277 shares of $1.00 par value common stock were outstanding.

SUMMIT FINANCIAL CORPORATION

FORM 10-Q FOR THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2004

TABLE OF CONTENTS OF INFORMATION REQUIRED IN REPORT

PART I. FINANCIAL INFORMATION
Item 1.

Consolidated Balance Sheets at June 30, 2004 and December 31, 2003	3

Consolidated Statements of Income for the Three Months and Six Months Ended June 30, 2004 and 2003	4

Consolidated Statements of Shareholders' Equity and Comprehensive Income for the Six Months Ended June 30, 2004 and 2003	5

Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003	6

Condensed Notes to Consolidated Financial Statements June 30, 2004	7

Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.
Quantitative and Qualitative Disclosures About Market Risk	28

Item 4.
Controls and Procedures	28

PART II. OTHER INFORMATION	29

SIGNATURES	30

EXHIBITS:
Exhibit 31.1 - Rule 13a-14(a) Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes Oxley Act of 2002
Exhibit 31.2 - Rule 13a-14(a) Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes Oxley Act of 2002
Exhibit 32.1 - Section 1350 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 - Section 1350 Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


	2

SUMMIT FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
(Unaudited)

		June 30,			December 31,
		2004			2003

ASSETS
Cash and due from banks	$	12,215		$	9,854
Interest-bearing bank balances		4,841			341
Federal funds sold		13,079			201
Investments available for sale		64,722			90,887
Investment in Federal Home Loan Bank and other stock		2,943			3,004
Loans, net of unearned income and net of
allowance for loan losses of $3,554 and $3,437		225,471			228,365
Premises and equipment, net		3,969			4,070
Accrued interest receivable		1,252			1,505
Other assets		6,489			5,694

	$	334,981		$	343,921

LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand	$	44,981		$	37,037
Interest-bearing demand		28,299			23,542
Savings and money market		75,254			73,245
Time deposits, $100,000 and over		50,390			65,200
Other time deposits		49,447			57,988

		248,371			257,012
Federal Home Loan Bank advances		50,751			52,317
Accrued interest payable		728			841
Other liabilities		1,594			1,546

		301,444			311,716

Shareholders' equity:
Common stock, $1.00 par value; 20,000,000
shares authorized; issued and
outstanding 4,452,034 and 4,312,925 shares		4,452			4,313
Additional paid-in capital		26,500			25,791
Retained earnings		3,897			2,102
Accumulated other comprehensive (loss) income, net of tax		(1,064	)		28
Nonvested resticted stock		(248	)		(29	)

Total shareholders' equity		33,537			32,205

	$	334,981		$	343,921

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


	3

SUMMIT FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars, except per share data, in Thousands)
(Unaudited)

	For the Three Months Ended						For the Six Months Ended
			June 30,					June 30,
			2004			2003		2004		2003

Interest Income:
Loans		$	3,430		$	3,554	$	6,968	$	7,126
Taxable investment securities			496			654		1,118		1,181
Nontaxable investment securities			220			178		470		348
Federal funds sold			17			3		20		23
Other			35			35		65		75

			4,198			4,424		8,641		8,753

Interest Expense:
Deposits			724			940		1,487		1,892
Other			414			423		830		840

			1,138			1,363		2,317		2,732

Net interest income			3,060			3,061		6,324		6,021
Provision for loan losses			(50	)		229		160		402

Net interest income after provision for loan losses			3,110			2,832		6,164		5,619

Noninterest income:
Service charges and fees on deposit accounts			127			137		260		274
Credit card service fees and income			98			113		200		213
Insurance commission fee income			111			116		251		214
Gain on sale of securities			-			181		22		355
Other income			263			308		486		560

			599			855		1,219		1,616

Noninterest expenses:
Salaries, wages and benefits			1,343			1,279		2,705		2,593
Occupancy			152			165		326		333
Furniture, fixtures and equipment			156			160		313		320
Other expenses			455			544		1,004		1,124

			2,106			2,148		4,348		4,370

Income before income taxes			1,603			1,539		3,035		2,865
Provision for income taxes			483			480		928		897

Net income		$	1,120		$	1,059	$	2,107	$	1,968

Net income per share:
Basic		$	.25		$	.25	$	.48	$	.47
Diluted		$	.23		$	.22	$	.43	$	.41
Average shares outstanding:
Basic			4,432,000			4,253,000		4,376,000		4,233,000
Diluted			4,944,000			4,842,000		4,901,000		4,812,000

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


	4

SUMMIT FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME
FOR THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(Dollars in Thousands)
(Unaudited)

									Accumulated
									other
				Additional					comprehensive		Nonvested			Total
		Common		paid-in		Retained			(loss)		restricted			shareholders'
		stock		capital		earnings			income, net		stock			equity


Balance at December 31, 2002	$	4,013	$	21,322	$	2,862		$	600		($55	)	$	28,742
Net income for the six months ended June 30, 2003		-		-		1,968			-		-			1,968
Other comprehensive income:
Unrealized gain on securities:
Unrealized holding gains arising during the period,
net of tax of $386		-		-		-			631		-			-
Less: reclassification adjustment for gains included
in net income, net of tax of ($134)		-		-		-			(221	)	-			-

Other comprehensive income		-		-		-			410		-			410

Comprehensive income		-		-		-			-		-			2,378

Stock options exercised		45		185		-			-		-			230
Amortization of deferred
compensation on restricted stock		-		-		-			-		13			13

Balance at June 30, 2003	$	4,058	$	21,507	$	4,830		$	1,010		($42	)	$	31,363


Balance at December 31, 2003	$	4,313	$	25,791	$	2,102		$	28		($29	)	$	32,205
Net income for the six months ended June 30, 2004		-		-		2,107			-		-			2,107
Other comprehensive loss:
Unrealized loss on securities:
Unrealized holding losses arising during the period,
net of tax of ($661)		-		-		-			(1,078	)	-			-
Less: reclassification adjustment for gains included
in net income, net of tax of $8		-		-		-			(14	)	-			-

Other comprehensive loss		-		-		-			(1,092	)	-			(1,092	)

Comprehensive income		-		-		-			-		-			1,015

Stock options exercised		125		471		-			-		-			596
Stock issued pursuant to restricted stock plan		14		238		-			-		(252	)		-
Amortization of deferred
compensation on restricted stock		-		-		-			-		33			33
Cash dividends declared ($0.07 per share)		-		-		(312	)		-		-			(312	)

Balance at June 30, 2004	$	4,452	$	26,500	$	3,897			($1,064	)	($248	)	$	33,537

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


	5

SUMMIT FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in Thousands)
(Unaudited)

	For the Six Months Ended
		June 30,

		2004			2003

Cash flows from operating activities:
Net income	$	2,107		$	1,968
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses		160			402
Depreciation and amortization		212			222
Net gain on sale of and disposal of equipment and vehicles		(22	)		(30	)
Net gain on sale of investments available for sale		(22	)		(355	)
Net amortization of net premium on investments		68			154
Amortization of deferred compensation on restricted stock		33			13
Decrease (increase) in other assets		174			(26	)
Decrease in other liabilities		(65	)		(139	)
Deferred income taxes		(47	)		(92	)

Net cash provided by operating activities		2,598			2,117

Cash flows from investing activities:
Purchases of securities available for sale		(3,398	)		(55,994	)
Proceeds from maturities of securities available for sale		9,041			21,285
Proceeds from sales of securities available for sale		18,715			24,170
Purchases of investments in FHLB and other stock		(68	)		(400	)
Redeemption of FHLB stock		129			-
Net reduction (increase) in loans		2,734			(3,606	)
Purchases of premises and equipment		(111	)		(160	)
Proceeds from sale of equipment and vehicles		22			49

Net cash provided by (used in) investing activities		27,064			(14,656	)

Cash flows from financing activities:
Net (decrease) increase in deposit accounts		(8,641	)		13,437
Proceeds from Federal Home Loan Bank advances		4,000			15,675
Repayments of Federal Home Loan Bank advances		(5,566	)		(10,500	)
Cash dividends declared		(312	)		-
Proceeds from employee stock options exercised		596			230

Net cash (used in) provided by financing activities		(9,923	)		18,842

Net increase (decrease) in cash and cash equivalents		19,739			6,303
Cash and cash equivalents, beginning of period		10,396			11,596

Cash and cash equivalents, end of period	$	30,135		$	17,899

SUPPLEMENTAL INFORMATION:
Cash paid during the period for interest	$	2,430		$	2,965
Cash paid during the period for income taxes	$	1,000		$	1,010
Change in market value of investment securities available for sale, net of income taxes		($1,092	)	$	410

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


	6

SUMMIT FINANCIAL CORPORATION

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2004

NOTE 1 - BASIS OF PRESENTATION:

The unaudited consolidated financial statements include the accounts of Summit Financial Corporation (the “Company”), a South Carolina corporation, and its wholly-owned subsidiaries, Summit National Bank (the “Bank”), a nationally chartered bank, and Freedom Finance, Inc. (the “Finance Company”), a consumer finance company. Also included are the accounts of Summit Investment Services, Inc. (the “Investment Company”) which is a wholly-owned subsidiary of the Bank. All significant intercompany items related to the consolidated subsidiaries have been eliminated.

Through its bank subsidiary, which commenced operations in July 1990, the Company provides a full range of banking services, including the taking of demand and time deposits and the making of commercial and consumer loans. The Bank currently has four full service branch locations in Greenville and Spartanburg, South Carolina. In 1997, the Bank incorporated the Investment Company as a wholly-owned subsidiary to offer nondeposit products and financial management services. The Finance Company commenced operations in November 1994 and makes and services small installment loans to individuals from its eleven offices throughout South Carolina.

The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) which requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. In addition, the estimates affect the reported income and expense during the reporting period. Actual results could differ from these estimates and assumptions.

The significant accounting policies followed by the Company for interim reporting are consistent with the accounting policies followed for annual financial reporting. The unaudited consolidated financial statements of the Company at June 30, 2004 and for the three month and six month periods ended June 30, 2004 and 2003 were prepared in accordance with the instructions for Form 10-Q. In the opinion of management, all adjustments (consisting only of items of a normal recurring nature) necessary for a fair presentation of the financial position at June 30, 2004, and the results of operations and cash flows for the periods ended June 30, 2004 and 2003 have been included. The information contained in the footnotes included in the Company's latest annual report on Form 10-K for the year ended December 31, 2003 should be referred to in connection with the reading of these unaudited interim consolidated financial statements. Certain interim 2003 amounts have been reclassified to conform with the statement presentations for the interim 2004 period and to reflect the effect of the 5% stock dividend paid in December 2003.

The results for the three month and six month period ended June 30, 2004 are not necessarily indicative of the results that may be expected for the full year or any other interim period.

NOTE 2 - CASH FLOW INFORMATION:

For the purposes of reporting cash flows, cash includes currency and coin, cash items in process of collection and due from banks. Included in cash and cash equivalents are federal funds sold and overnight investments. The Company considers the amounts included in the balance sheet line items, “Cash and due from banks”, “Interest-bearing bank balances” and “Federal funds sold” to be cash and cash equivalents. These accounts totaled $30,135,000 and $17,899,000 at June 30, 2004 and 2003, respectively.


	7

NOTE 3 – INVESTMENT SECURITIES:

All investment securities are classified as “Available for Sale” for each period presented and accounted for in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. At June 30, 2004, the investment security portfolio had an unrealized loss of ($1.7 million). This is compared to an unrealized gain of $45,000 at December 31, 2003. The securities contributing to the unrealized loss are considered to have a temporary impairment in value resulting primarily from the significant market shifts in the Treasury yield curve over the past year. The Company has demonstrated an ability to hold securities until maturity, thus an actual loss may not be realized. There has been no credit quality deterioration of any of the securities with unrealized losses and the agency securities carry the implied guarantee of the U.S. Government.

NOTE 4 – STOCK COMPENSATION PLANS:

At June 30, 2004, the Company had three stock-based employee and director option plans, which are described more fully in Note 13 of the Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for December 31, 2003. The Company reports stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion 25, “Accounting for Stock Issued to Employees”, which measures compensation expense as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. SFAS 123, “Accounting for Stock-Based Compensation”, encourages but does not require companies to record compensation cost for stock-based compensation plans at fair value. Accordingly, no compensation cost has been recognized for the stock-based option plans as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee and non-employee compensation.

	For the Three Months Ended June 30,				For the Six Months Ended June 30,

(dollars, except per share, in thousands)		2004		2003		2004		2003

Net income, as reported	$	1,120	$	1,059	$	2,107	$	1,968
Less - total stock-based employee compensation expense determined under fair value based method, net of taxes		31		42		62		84

Proforma net income	$	1,089	$	1,017	$	2,045	$	1,884

Earnings per share:
Basic - as reported	$	0.25	$	0.25	$	0.48	$	0.47
Basic – proforma	$	0.25	$	0.24	$	0.47	$	0.45
Diluted - as reported	$	0.23	$	0.22	$	0.43	$	0.41
Diluted – proforma	$	0.22	$	0.21	$	0.42	$	0.39

NOTE 5 – INTANGIBLE ASSETS:

As of January 1, 2002, the Company adopted SFAS 142, “Goodwill and Other Intangible Assets”. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. The Company’s intangible assets consist of goodwill resulting from the Finance Company’s branch acquisitions and are included in “Other assets” on the accompanying consolidated balance sheets. The balance of goodwill at June 30, 2004 and December 31, 2003 was $187,000. There was no amortization expense charged in any period presented.


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NOTE 6 – PER SHARE INFORMATION:

The following is a reconciliation of the denominators of the basic and diluted per share computations for net income for the three months and six months ended June 30, 2004 and 2003. There is no required reconciliation of the numerator from the net income reported on the accompanying statements of income. All average share and per share data have been restated to reflect all stock dividends as of the earliest period presented.

	For the Three Months Ended June 30,

		2004		2004		2003		2003

		BASIC		DILUTED		BASIC		DILUTED

Net Income	$	1,119,812	$	1,119,812	$	1,059,003	$	1,059,003

Average shares outstanding		4,432,462		4,432,462		4,253,382		4,253,382
Effect of Dilutive Securities:
Stock options		-		494,269		-		583,218
Unvested restricted stock		-		16,917		-		5,835

		4,432,462		4,943,648		4,253,382		4,842,435

Per-share amount	$	0.25	$	0.23	$	0.25	$	0.22


	For the Six Months Ended June 30,

		2004		2004		2003		2003

		BASIC		DILUTED		BASIC		DILUTED

Net Income	$	2,107,311	$	2,107,311	$	1,968,459	$	1,968,459

Average shares outstanding		4,376,091		4,376,091		4,233,141		4,233,141
Effect of Dilutive Securities:
Stock options		-		507,500		-		573,115
Unvested restricted stock		-		16,917		-		5,835

		4,376,091		4,900,508		4,233,141		4,812,091

Per-share amount	$	0.48	$	0.43	$	0.47	$	0.41


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NOTE 7 – SEGMENT INFORMATION:

The Company reports information about its operating segments in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information”. Summit Financial Corporation is the parent holding company for Summit National Bank (“Bank”), a nationally chartered bank, and Freedom Finance, Inc. (“Finance”), a consumer finance company. The Company considers the Bank and the Finance Company separate business segments.

Financial performance for each segment is detailed in the following tables. Included in the “Corporate” column are amounts for general corporate activities and eliminations of intersegment transactions.

	For the three months ended June 30, 2004											At and for the six months ended June 30, 2004
		Bank			Finance		Corporate			Total			Bank		Finance		Corporate			Total

Interest income	$	3,799		$	399	$	0		$	4,198		$	7,790	$	854		($3	)	$	8,641
Interest expense		1,138			29		(29	)		1,138			2,317		60		(60	)		2,317

Net interest income		2,661			370		29			3,060			5,473		794		57			6,324
Provision for loan losses		(119	)		69		-			(50	)		26		134		-			160
Other income		533			81		(15	)		599			1,070		179		(30	)		1,219
Other expenses		1,756			341		9			2,106			3,652		681		15			4,348

Income before taxes		1,557			41		5			1,603			2,865		158		12			3,035
Income taxes		464			17		2			483			865		59		4			928

Net income	$	1,093		$	24	$	3		$	1,120		$	2,000	$	99	$	8		$	2,107

Net loans												$	222,841	$	2,731		($101	)	$	225,471

Total assets												$	331,920	$	3,159		($98	)	$	334,981



	For the three months ended June 30, 2003											At and for the six months ended June 30, 2003
		Bank			Finance		Corporate			Total			Bank		Finance		Corporate			Total

Interest income	$	3,991		$	438		($5	)	$	4,424		$	7,835	$	930		($12	)	$	8,753
Interest expense		1,363			37		(37	)		1,363			2,732		76		(76	)		2,732

Net interest income		2,628			401		32			3,061			5,103		854		64			6,021
Provision for loan losses		160			69		-			229			270		132		-			402
Other income		791			79		(15	)		855			1,476		170		(30	)		1,616
Other expenses		1,803			337		8			2,148			3,663		692		15			4,370

Income before taxes		1,456			74		9			1,539			2,646		200		19			2,865
Income taxes		449			27		4			480			815		75		7			897

Net income	$	1,007		$	47	$	5		$	1,059		$	1,831	$	125	$	12		$	1,968

Net loans												$	216,262	$	3,068		($695	)	$	218,635

Total assets												$	320,471	$	3,570		($741	)	$	323,300


	10

SUMMIT FINANCIAL CORPORATION

PART I. FINANCIAL INFORMATION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following information presents management’s discussion and analysis of the financial condition and results of operations of Summit Financial Corporation (“the Company” or “Summit Financial”), a financial holding company, and its wholly-owned subsidiaries, Summit National Bank (“the Bank” or “Summit”) and Freedom Finance, Inc. (“the Finance Company” or “Freedom”). The Bank, which is the principal subsidiary, owns all the outstanding shares of Summit Investment Services, Inc. Throughout this discussion and analysis, the term “the Company” refers to Summit Financial Corporation and its subsidiaries.

This discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Annual Report of Summit Financial Corporation (the “Company”) on Form 10K for the year ended December 31, 2003. Certain reclassifications have been made to prior years’ financial data to conform to current financial statement presentations as well as to reflect the effect of the 5% stock dividend paid in December 2003. Results of operations for the three month and six month periods ended June 30, 2004 are not necessarily indicative of results to be attained for any other period.

FORWARD-LOOKING STATEMENTS

Certain statements contained herein are “forward-looking statements” identified as such for purposes of the safe harbor provided in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, but are not limited to, statements as to industry trends, future results of operations or financial position, borrowing capacity and future liquidity, future investment results, future credit exposure, future loan losses and plans and objectives for future operations, and other statements that do not relate strictly to historical facts. These statements are not historical facts, but instead are based on current expectations, estimates and projections about the Company, are subject to numerous assumptions, risks and uncertainties, and represent only management’s belief regardi ng future events, many of which, by their nature, are inherently uncertain and outside the Company’s control. Any forward-looking statements made speak only as of the date on which such statements are made. The Company disclaims any obligation to update any forward-looking statements. Forward-looking statements are not guarantees of future performance and it is possible that actual results and financial position may differ, possibly materially, from the anticipated results and financial condition indicated in or implied by these forward-looking statements.

Factors that could cause actual results to differ from those indicated by any forward-looking statements include, but are not limited to, the following:

Inflation, interest rates, market and monetary fluctuations;
Geopolitical developments and any future acts or threats of war or terrorism;
The effects of, and changes in trade, monetary and fiscal policies and laws, including interest policies of the Federal Reserve;
A decline in general economic conditions and the strength of the local economies in which the Company operates;
The financial condition of the Company’s borrowers and potential deterioration of credit quality;
Competitive pressures on loan and deposit pricing and demand;
Changes in technology and their impact on the marketing of products and services;


	11

The timely development and effective marketing of competitive new products and services;
The impact of changes in financial service laws and regulations, including laws concerning taxes, banking, securities and insurance;
Changes in accounting principles, policies, and guidelines;
The Company’s success at managing the risks involved in the foregoing as well as other risks and uncertainties detailed from time to time in press releases and other public filings.

NON-GAAP FINANCIAL INFORMATION

This report contains certain financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The Company’s management uses these non-GAAP measures to analyze the Company’s performance. In particular, net interest income and net interest margin ratios are presented on a fully tax-equivalent basis. Management believes that the presentation of net interest margin on a fully tax-equivalent basis aids in the comparability of net interest margin arising from both taxable and tax-exempt sources. These disclosures should not be viewed as a substitute for GAAP measures, and furthermore, the Company’s non-GAAP measures may not necessarily be comparable to non-GAAP performance measures of other companies.

COMPANY BUSINESS

The Company is headquartered in Greenville, South Carolina. Through its primary subsidiary, the Bank, the Company offers a full range of financial products and services, including business and consumer loans, commercial and residential mortgage lending and brokerage, asset-based financing, corporate and consumer deposit services, and investment management services. The Bank currently has four full service offices in Greenville and Spartanburg, South Carolina. Freedom is a consumer finance company headquartered in Greenville, South Carolina. The Finance Company primarily makes and services installment loans to individuals with loan principal amounts generally not exceeding $2,000 and with maturities ranging from three to 18 months. Freedom operates 11 branches throughout South Carolina.

CRITICAL ACCOUNTING POLICIES

The preparation of consolidated financial statements requires management to make estimates and assumptions in the application of certain of its accounting policies about the effect of matters that are inherently uncertain. These estimates and assumptions affect the reported amounts of certain assets, liabilities, revenues and expenses. Different amounts could be reported under different conditions, or if different assumptions were used in the application of these accounting policies. The Company’s accounting policies are discussed in Note 1 under Notes to Consolidated Financial Statements included in the Company’s Form 10-K for December 31, 2003. Of these significant accounting policies, the Company has determined that accounting for the allowance for loan losses and income taxes are deemed critical because of the valuation techniques used, and the sensitivity of these fi nancial statement amounts to the methods, assumptions and estimates underlying these balances. Accounting for these critical areas requires the most subjective and complex judgments that could be subject to revision as new information becomes available.

The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. This estimate is based on the current economy’s impact on the timing and expected amounts of future cash flows on problem or impaired loans, as well as historical loss experience associated with homogenous pools of loans. The Company’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements.


	12

The income tax calculations reflect the current period income tax expense for all periods shown, as well as future tax liabilities associated with differences in the timing of expenses and income recognition for book and tax accounting purposes. The income tax returns, usually filed six months after year-end, are subject to review and possible revision by the tax authorities up until the statute of limitations has expired. These statutes usually expire three years after the time the respective tax returns have been filed.

BALANCE SHEET ACTIVITY

Total assets decreased $8.9 million or 3% from December 31, 2003 to June 30, 2004 to total $335.0 million. The decrease was primarily related to a reduction in investment securities from sales, calls, and maturities totaling $26.2 million. A portion of the liquidity generated from the sales of securities was temporarily invested in overnight federal funds sold until needed for loan originations and maturing deposits or FHLB advances. This resulted in an increase in federal funds sold from year end of $12.9 million and interest-bearing deposits of $4.5 million. The decision to restructure the balance sheet through the sale of investment securities was a strategy to manage the expectations of further changes in the treasury market. The securities selected for sale were to reposition the investment portfolio to reduce the price risk and volatility, and to reduce the extension risk ari sing from increases in the treasury yield curve resulting in a slow down in cash flows from mortgage-backed securities and callable agency securities.

Deposits decreased $8.6 million or 3% during the period to total $248.4 million. A majority of the decrease in deposits was in the time deposit categories, and were primarily non-core deposit accounts from outside the local market which management made a strategic decision to let leave the Bank upon maturity. Management made the decision to not retain these deposits in order to reduce the Bank’s cost of funds, return the loan-to-deposit ratios to more historic levels in order to maximize net interest margin, and to focus on local market deposits.

In addition to the retention of earnings, total equity increased $1.3 million, or 4%, related to the exercise of stock options during the first six months of the year. Increases in equity were partially offset by cash dividend of $312,000 declared in June 2004, and the higher unrealized loss on investment securities, net of taxes, totaling $1,064,000 at June 30, 2004, compared to an unrealized gain of $28,000 at December 31, 2003. The securities contributing to the unrealized loss are considered to have a temporary impairment in value resulting primarily from the significant market shifts in the Treasury yield curve over the past year. The Company has demonstrated an ability to hold securities until maturity, thus an actual loss may not be realized. There has been no credit quality deterioration of any of the securities with unrealized losses and the agency securities carry the imp lied guarantee of the U.S. Government.

ALLOWANCE FOR LOAN LOSSES AND NON-PERFORMING ASSETS

The allowance for loan losses is established through charges in the form of a provision for loan losses based on management’s periodic evaluation of the loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. The amount of the allowance reflects management’s opinion of an adequate level to absorb probable losses inherent in the loan portfolio at June 30, 2004. In assessing the adequacy of the allowance and the amount charged to the provision, management relies predominately on its ongoing review of the loan portfolio, which is undertaken both to ascertain whether there are losses which must be charged-off, and to assess the risk characteristics of the portfolio in the aggregate as well as the credit risk associated with particular loans. The Company’s methodology for evaluating the adequacy of the allowance for loan losses incorp orates management’s current judgments about the credit quality of the loan portfolio through a disciplined and consistently applied process. The methodology includes segmentation of the loan portfolio into reasonable components based on loan purpose for calculation of the most accurate reserve. Appropriate reserve estimates are determined for each segment based on a review of individual loans, application of historical loss factors for each segment, and adjustment factors applied as considered necessary. The adjustment factors are applied consistently and are quantified for consideration of national and local economic conditions; exposure to concentrations that may exist in the portfolio; impact of off-balance sheet risk; alterations of lending policies and procedures; the total amount of and changes in trends of past due loans, nonperforming loans, problem loans and charge-offs; the total amount of and changes in trends of the Bank’s classified loans; variations in the nature, maturity, compositio n, and growth of the loan portfolio; changes in trends of collateral value; entry into new markets; and other factors which may impact the current credit quality of the loan portfolio.


	13

Management maintains an allowance for loan losses which it believes adequate to cover probable losses in the loan portfolio. It must be emphasized, however, that the determination of the allowance for loan losses using the Company’s procedures and methods rests upon various judgments and assumptions about future economic conditions, events, and other factors affecting loans which are believed to be reasonable, but which may or may not prove valid. While it is the Company’s policy to provide for the loan losses in the current period in which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, industry trends, and conditions affecting individual borrowers, management’s judgment of the allowance is neces sarily approximate and imprecise. No assurance can be given that the Company will not in any particular period sustain loan losses which would be sizable in relationship to the amount reserved or that subsequent evaluation of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. The allowance for loan losses is also subject to review by various regulatory agencies through their periodic examinations of the Company’s subsidiaries. Such examination could result in required changes to the allowance for loan losses. No adjustment in the allowance or significant adjustments to the Bank’s internal classified loans were made as a result of the Bank’s most recent examination performed by the Office of the Comptroller of the Currency.

The following table sets forth certain information with respect to changes in the Company’s allowance for loan losses for each period presented.

(dollars in thousands)	At and For the Six Months Ended June 30, 2004				At and For the Year Ended December 31, 2003			At and For the Six Months Ended June 30, 2003

Balance at beginning of period		$	3,437		$	3,369		$	3,369

Charge-offs:
Commercial and industrial			-			167			37
Commercial real estate			30			388			115
Installment and consumer			230			519			180

			260			1,074			332

Recoveries:
Commercial and industrial			33			2			-
Commercial real estate			115			205			151
Installment and consumer			69			149			42

			217			356			193

Net charge-offs			(43	)		(718	)		(139	)
Provision charged to expense			160			786			402

Balance at end of period		$	3,554		$	3,437		$	3,632

Net charge-offs to average loans, annualized			0.04	%		0.32	%		0.12	%

Allowance to loans, period end			1.55	%		1.48	%		1.63	%


	14

The Company’s nonperforming assets consist of loans on non-accrual basis, loans which are contractually past due 90 days or more on which interest is still being accrued, troubled debt restructurings, and other real estate owned (“OREO”). Generally, loans of the Bank are placed on non-accrual status at the earlier of when they are 90 days past due or when the collection of the loan becomes doubtful. Loans of the Finance Company are not classified as non-accrual, but are charged-off when such become 150 days contractually past due or earlier if the loan is deemed uncollectible. There were no loans considered to be impaired under Statement of Financial Accounting Standards (“SFAS”) 114, “Accounting by Creditors for Impairment of a Loan” for any period presented. The following table summarizes the nonper forming assets for each period presented.

(dollars in thousands)		June 30, 2004		December 31, 2003				June 30, 2003

Loans past due 90 days or more, still accruing	$	125		$	170		$	137
Non-accrual loans		189			587			591
Troubled debt restructurings		-			-			-
Other real estate owned		230			125			-

Total nonperforming assets	$	544		$	882		$	728

Nonperforming assets to total loans and OREO		0.24	%		0.38	%		0.33	%

Management maintains a list of potential problem loans which includes non-accrual loans, loans past due in excess of 90 days which are still accruing interest, and other loans which are credit graded (either graded internally, by independent review or regulatory examinations) as “watch”, “OAEM”, “substandard”, “doubtful”, or “loss”. A loan is added to the list when management becomes aware of information about possible credit problems of borrowers that causes doubts as to the ability of such borrowers to comply with the current loan repayment terms. The total amount of adversely classified loans (i.e., defined as loans with a credit grade of “substandard”, “doubtful”, or “loss”) at June 30, 2004 was $7.6 million or 3.3% of the loan portfolio at June 30, 2004, compared to $3.5 million or 1.5% of the loan portfolio at December 31, 2003, and $3.1 million or 1.4% of the loan portfolio at June 30, 2003. The amount of potential problem loans at June 30, 2004 does not represent management’s estimate of potential losses since the majority of such loans are considered adequately secured by real estate or other collateral. Although adversely classified loans have increased somewhat during the six months ended June 30, 2004, loans classified as OAEM have decreased substantially by $10.7 million since December 31, 2003. The overall decrease in the amount of classified loans in 2004 is primarily related to the significant payoffs and paydowns in loans and management proactively worked these loans to improve the quality of the portfolio, as well as an improvement in the general economic conditions during the period. Management believes that the allowance for loan losses as of June 30, 2004 is adequate to absorb any losses related to the nonperforming loans and potential problem loans as of that date. Management con tinues to monitor closely the levels of nonperforming and potential problem loans, and will address the weaknesses in these credits to enhance the amount of ultimate collection or recovery on these assets. Should increases in the overall level of nonperforming and potential problem loans accelerate from the current trend, management will adjust the methodology for determining the allowance for loan losses and will increase the provision for loan losses accordingly. This would likely decrease net income.

The allowance for loan losses totaled $3.6 million, or 1.55% of total loans, at June 30, 2004. This is compared to a $3.4 million allowance, or 1.48% of total loans, at December 31, 2003, and $3.6 million, or 1.63% of total loans at June 30, 2003. The fluctuations in the allowance for loan losses as a percent of loans between June 30, 2003, December 31, 2003 and June 30, 2004 is reflective of the factors discussed previously, as well as under the “Provision for Loan Losses” section below, primarily related to change in levels of and trends in classified loans between the periods.


	15

EARNINGS REVIEW – COMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2004 AND 2003

GENERAL

The Company reported consolidated net income for the three months ended June 30, 2004 of $1,120,000, compared to net income of $1,059,000 for the three months ended June 30, 2003, or an improvement of approximately $61,000 or 6%. The primary contributors to increased earnings for the second three months of 2004 was the lower provision for loan losses and control of overhead expenses. The reduction in the provision for loan losses was related to the $11.2 million reduction in loans outstanding during the second quarter of 2004. Also contributing to the negative provision for the quarter, discussed further below, is the overall improvement of credit quality in the loan portfolio as demonstrated by the reduction in net charge-offs, nonperforming assets and classified loans since year end. The increases in income were somewhat offset by the 30% reduction in other income as a result of lower gains on sales of investment securities and mortgage referral fees.

NET INTEREST INCOME

Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company’s earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During both the quarters ended June 30, 2004 and June 30, 2003, the Company recorded net interest income of $3.1 million. The 2% increase in average earning assets between the two periods was offset by the 6 basis point (2%) reduction in net interest margin, thus the nominal reduction of $1,000 from the second quarter of 2003 to the second quarter of 2004.

For the three months ended June 30, 2004 and June 30, 2003, the Company’s net interest margin was 4.04% and 4.10%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The decrease in net interest margin is related primarily to the 39 basis point reduction in the average yield on assets, offset somewhat by the 35 basis point reduction in the average cost of funds. Rates on both assets and liabilities declined in 2003 and into 2004 due to the general low interest rate environment and the maturity of higher priced investments, loans, deposits and other borrowings which were reinvested or renewed at lower current market rates. During the period between the second quarter of 2003 and 2004, the average prime rate decreased 24 basis points to 4.00%.

INTEREST INCOME

For the three months ended June 30, 2004, the Company’s earning assets averaged $316.1 million and had an average yield of 5.48%. This compares to average earning assets of $308.8 million for the second quarter of 2003, yielding approximately 5.87%. Thus, the 39 basis point decrease in average yield, offset somewhat by the 2% increase in volume of average earning assets, accounts for the $226,000 (5%) decrease in interest income between the second quarters of 2003 and 2004.

Gross loans comprised approximately 74% of the Company’s average earning assets for the second quarter of 2004 and compared to 73% for the second quarter of 2003. The majority of the Company’s loans are tied to the prime rate (over 70% of the Bank’s loan portfolio is at floating rates at June 30, 2004), which averaged 4.00% and 4.24% for the quarters ended June 30, 2004 and 2003, respectively. During the second quarter of 2004, loans averaged $234.9 million, yielding an average of 5.87%, compared to $225.7 million, yielding an average of 6.32% for the second three months of 2003. The 45 basis point decrease in the average yield on loans is directly related to the reductions in the general interest rate environment and lower prime lending rate between 2003 and 2004, combined with the repricing and renewal of fixed rate loans at lower current market rates. The 4% incre ase in average loans was more than offset by the lower average yields and resulted in the reduction in interest income on loans of $124,000 or 3.5%.


	16

Investment securities averaged $67.3 million or 21% of average earning assets and yielded 4.92% (tax equivalent basis) during the second quarter of 2004, compared to average securities of $76.7 million yielding 4.83% (tax equivalent basis) for the three months ended June 30, 2003. The 10 basis point increase in the average yield of the investment portfolio is related to the general increase in treasury market interest rates during 2004, sales of lower yielding investments during the period, the overall portfolio mix, and the slow down in mortgage-backed securities principal payments. As of June 30, 2004, the portfolio had a weighted average life of approximately 6.9 years and an average duration of 5.5 years. This is compared to a weighted average life of 7.7 years and an average duration of 6.0 years as of December 31, 2003. The 12% decrease in average securities, offset somewhat by the increase in yield, resulted in the net decrease of interest income on taxable and nontaxable investments of $116,000 or 14%.

INTEREST EXPENSE

The Company’s interest expense for the three months ended June 30, 2004 was $1.1 million. The decrease in interest expense of $225,000, or 17%, from the comparable quarter in 2003 of $1.4 million was related primarily to the 35 basis point decrease in the average rate on liabilities, offset by the slight increase in the level of average interest-bearing liabilities. Interest-bearing liabilities averaged $260.2 million for the second quarter of 2004 with an average rate of 1.76%. This is compared to average interest-bearing liabilities of $258.9 million with an average rate of 2.11% for the quarter ended June 30, 2003. The decrease in average rate on liabilities is directly related to the general reductions in market interest rates and the maturities of fixed rate deposits and other borrowings which were renewed at lower current market rates.

PROVISION FOR LOAN LOSSES

The provision for loan losses was a negative ($50,000) for the second quarter of 2004, compared to expense of $229,000 for the comparable period of 2003. As discussed further under the “Allowance for Loan Losses” section above, in addition to the level of net originations, other factors influencing the amount charged to the provision each period include (1) trends in and the total amount of past due, nonperforming, and classified loans; (2) trends in and the total amount of net chargeoffs, (3) concentrations of credit risk in the loan portfolio, and (4) local and national economic conditions and anticipated trends. Thus, the $279,000 or 122% decrease in the provision for loan losses is related to the net reduction in loans outstanding in the second quarter of 2004 of $11.2 million compared to net origination of $2.8 million for the second quarter of 2003. In addition, con tributing to the negative provision expense for the quarter is the overall improvement in credit quality of the loan portfolio as evidenced by the reduction in net charge-offs, past due loans, nonperforming assets and classified loans. Estimates charged to the provision for loan losses are based on management’s judgment as to the amount required to cover probable losses in the loan portfolio and are adjusted as necessary based on a calculated model quantifying the estimated required balance in the allowance.

NONINTEREST INCOME AND EXPENSES

Noninterest income, which is primarily related to service charges on customers’ deposit accounts; credit card merchant discount fees; commissions on nondeposit investment product sales and insurance product sales; mortgage origination fees; and gains on sales of investment securities, was $599,000 for the three months ended June 30, 2004 compared to $855,000 for the second quarter of 2003, or a decrease of 30%. The decrease is related to the lower gains on sales of securities, which decreased $181,000 due to the reduction in volume of sales transactions. Also contributing to the lower other income was a reduction in mortgage referral fees, which decreased $55,000 as compared to the second quarter of 2003.


	17

For both the three months ended June 30, 2004 and 2003, noninterest expense was $2.1 million. The most significant item included in noninterest expense is salaries, wages and benefits, which totaled $1.3 million for both the three months ended June 30, 2004 and 2003. The increase of $64,000 or 5% is primarily a result of normal annual raises and higher group insurance costs, offset somewhat by lower bonus accruals in 2004.

Occupancy and furniture, fixtures, and equipment (“FFE”) expenses decreased a total of $17,000 or 5% between the second quarter of 2003 and 2004. The decrease was due primarily to an adjustment in property taxes for one of the Company’s branch locations, and lower depreciation due to assets which became fully depreciated in 2003. There were no significant changes in or additions to property and premises between the two quarterly periods.

Included in the line item “other expenses”, which decreased $89,000 or 16% from the comparable period of 2003, are charges for OCC assessments; property and bond insurance; ATM switch fees; professional services; education and seminars; advertising and public relations; and other branch and customer related expenses. The decrease is primarily related to lower advertising ($60,000), consultant fees ($31,000), and other professional fees ($28,000) in 2004 due to changes in the promotional campaigns and other programs of the Company requiring these services. Somewhat offsetting these decreases is higher loan collection costs of $50,000 related to reducing the balances in OREO, nonaccrual and other classified loans. Fluctuations in other expense categories are primarily related to deposit related expenses and are a result of normal activity of the Company and normal changes i n the volume and nature of transactions.

INCOME TAXES

For the three months ended June 30, 2004, the Company reported $483,000 in income tax expense, or an effective tax rate of 30.1%. This is compared to income tax expense of $480,000 for the same period of the prior year, or an effective tax rate of 31.2%. The slight reduction in effective tax rate is primarily related to the level of tax-free municipal securities in each period.

EARNINGS REVIEW – COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003

GENERAL

The Company reported consolidated net income for the six months ended June 30, 2004 of $2,107,000, compared to net income of $1,968,000 for the six months ended June 30, 2003, or an improvement of approximately $139,000 or 7%. The primary factors in the increased earnings from the same period of the prior year were the 6% increase in average earning assets, the 15% reduction in interest expense due to lower cost of funds, and the lower provision for loan losses resulting from lower net originations during the period and the improvement in overall quality of the loan portfolio. The increases in income were somewhat offset by the 25% reduction in other income as a result of lower gains on sales of investment securities and lower mortgage referral fees.

NET INTEREST INCOME

Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company's earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During the six months ended June 30, 2004, the Company recorded consolidated net interest income of $6.3 million, a 5% increase from the net interest income of $6.0 million for the six months ended June 30, 2003. The increase in this amount is directly related to the increase in the average earning asset and interest-bearing liability volume of the Company of 6% and 5%, respectively, offset somewhat by the slight reduction in net interest margin between the comparable periods.


	18

For the six months ended June 30, 2004 and 2003, the Company's consolidated net interest margin was 4.15% and 4.16%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The slight decrease in net interest margin is related primarily to the 39 basis point reduction in the average yield on assets, offset by the 42 basis point reduction in the average cost of funds. The average prime rate decreased 25 basis points to 4.00% for the six months ended June 30, 2004.

INTEREST INCOME

For the six months ended June 30, 2004, the Company's earning assets averaged $318.1 million and had an average tax-equivalent yield of 5.61%. This compares to average earning assets of $300.4 million for the first six months of 2003, yielding 6.00%. Thus, the 6% increase in volume of average earning assets, which was more than offset by the 39 basis point decrease in average yield, accounts for the $112,000 (1%) decrease in interest income between the comparable six month periods of 2004 and 2003.

Consolidated loans averaged approximately 74% of the Company’s average earning assets for both of the first six months of 2004 and 2003. The majority of the Company’s loans are tied to the prime rate (over 70% of the Bank’s portfolio is at floating rates at June 30, 2004), which averaged 4.00% and 4.25% for the six months ended June 30, 2004 and 2003, respectively. During the first six months of 2004, consolidated loans averaged $235.4 million, yielding an average of 5.95%, compared to $222.1 million, yielding an average of 6.47% for the first six months of 2003. The 52 basis point decrease in the average yield on loans is primarily related to the lower prime lending rate which decreased 25 basis points between 2003 and 2004, combined with the renewal and refinancing of fixed rate loans to lower current market rates. The 6% increase in average loans, offset by the de crease in average rate, resulted in a decrease in consolidated interest income on loans of $158,000 or 2%.

Investment securities averaged $73.3 million or 23% of average earning assets and yielded 4.99% (tax equivalent basis) during the first six months of 2004, compared to average securities of $68.3 million yielding 5.04% (tax equivalent basis) for the six months ended June 30, 2003. The slight decrease in average yield on the investment portfolio is related to the general decline in market interest rates, the timing and volume of security maturities, calls, and sales which were reinvested in instruments with lower current market rates, and the portfolio mix. The 7% increase in volume of investment securities, offset somewhat by the reduction in average rate, resulted in the net increase in interest income on taxable and nontaxable investments of $59,000 or 4%.

INTEREST EXPENSE

The Company's interest expense for the six months ended June 30, 2004 was $2.3 million. The decrease of 15% from the comparable six months in 2003 of $2.7 million was directly related to the 42 basis point decrease in the average rate on liabilities, offset somewhat by the 5% increase in the volume of average interest-bearing liabilities. Interest-bearing liabilities averaged $264.3 million for the first six months of 2004 with an average rate of 1.76%. This is compared to average interest-bearing liabilities of $252.7 million with an average rate of 2.18% for the six months ended June 30, 2003. The decrease in average rate on liabilities is directly related to the general low level of market interest rates and the maturities of fixed rate deposits which were renewed at lower current market rates.


	19

PROVISION FOR LOAN LOSSES

As previously discussed under the quarterly analysis above, the amount charged to the provision for loan losses by the Bank and the Finance Company is based on management's judgment as to the amounts required to maintain an allowance adequate to provide for probable losses inherent in the loan portfolio.

LIQUIDITY

Liquidity risk is defined as the risk of loss arising from the Company’s inability to meet known near-term and projected long-term funding commitments and cash flow requirements. The objective of liquidity risk management is to ensure the ability of the Company to meet its financial obligations. These obligations are the payment of deposits on demand or at their contractual maturity; the repayment of borrowings as they mature; the payment of lease obligations as they become due; the ability to fund new and existing loan and other commitments; the payment of operating expenses; and the ability to take advantage of new business opportunities. Liquidity is measured and monitored frequently at both the parent company and the Bank levels, allowing management to better understand and react to balance sheet trends. A comprehensive liquidity analysis provides a summary of anticipated changes in loans, core deposits, and wholesale funds. Management also maintains a detailed liquidity contingency plan designed to respond to an overall decline in the condition of the banking industry or a problem specific to the Company.

Liquidity is achieved by the maintenance of assets which can easily be converted to cash; a strong base of core customer deposits; maturing short-term assets; the ability to sell marketable securities; and access to borrowed funds and capital markets. Historically, deposits have been the primary source of funds for lending and investing activities. The amortization and scheduled payment of loans and mortgage-backed securities and maturities of investment securities provide a stable source of funds, while deposit fluctuations and loan prepayments are significantly influenced by the interest rate environment and other market conditions and competitive factors. Management meets frequently and makes changes relative to the mix, maturity and pricing of assets and liabilities in order to minimize the impact on earnings from such external conditions. Deposits are attra ctive sources of liquidity because of their stability and generally lower cost than other funding.

In addition to deposits and normal cash flows, FHLB advances and short-term borrowings (including purchasing federal funds from other financial institutions or lines of credit through the Federal Reserve Bank) provide liquidity sources based on specific needs or if management determines that these are the best sources of funds to meet current requirements. At June 30, 2004, based on its approved line of credit equal to 25% of total assets and limited to eligible collateral available, the Bank had additional available credit of approximately $4.8 million from the FHLB. Further, the Bank had short-term lines of credit to purchase unsecured federal funds from unrelated correspondent banks with available balances of $23.1 million at June 30, 2004. The Bank considers advances from the FHLB to be a reliable and readily available source of funds for both liquidity purposes and asset-liabi lity management and interest rate risk management strategies.

Liquid assets, consisting primarily of cash and due from banks, interest-bearing deposits at banks, federal funds sold, and unpledged investment securities available for sale, accounted for 14% and 16%, respectively, of average assets for each of the six month period ended June 30, 2004 and 2003. Investment securities are an important tool to the Company’s liquidity management. Securities classified as available for sale may be sold in response to changes in interest rates, liquidity needs, and/or significant prepayment risk. In management’s opinion, the Company maintains adequate levels of liquidity by retaining sufficient liquid assets and assets which can be easily converted into cash and by maintaining access to various sources of funds.

As of June 30, 2004, there was no substantial change from the future contractual obligations as of December 31, 2003 as presented in the Company’s 2003 Annual Report on Form 10-K. The foregoing disclosures related to the liquidity of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2003 included in the Company’s 2003 Annual Report on Form 10-K.


	23

Summit Financial, the parent holding company, has limited liquidity needs required to pay operating expenses and to provide funding to its consumer finance subsidiary, Freedom Finance. Summit Financial has approximately $2.6 million in available liquidity remaining from its initial public offering and the retention of earnings. In addition, a total of $2.2 million of Summit Financial’s funds were advanced to the Finance Company, in the form of an intercompany loan, to fund its operations as of June 30, 2004. This amount could be replaced by a loan from an unrelated source to create additional liquidity for Summit Financial. Other sources of liquidity for Summit Financial include borrowing funds from unrelated correspondent banks, borrowing from individuals, and receipt of management fees and debt service from the Company’s subsidiary on a monthly basis.

Liquidity needs of Freedom Finance, primarily for the funding of loan originations, paying operating expenses, and servicing debt, have been met to date through the initial capital investment of $500,000 made by Summit Financial, retention of earnings, borrowings from unrelated private investors as necessary, and line of credit facilities provided by Summit Financial and Summit National Bank. The Company’s management believes its liquidity sources are adequate to meet its operating needs.

OFF-BALANCE SHEET ARRANGEMENTS

The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the liquidity, credit enhancement, and financing needs of its customers. These financial instruments include legally binding commitments to extend credit and standby letters of credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Credit risk is the principal risk associated with these instruments. The contractual amounts of these instruments represent the amount of credit risk should the instruments be fully drawn upon and the customer defaults.

To control the credit risk associated with entering into commitments and issuing letters of credit, the Company uses the same credit quality, collateral policies, and monitoring controls in making commitments and letters of credit as it does with its lending activities. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation.

Legally binding commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit obligate the Company to meet certain financial obligations of its customers, if, under the contractual terms of the agreement, the customers are unable to do so. The financial standby letters of credit issued by the Company are irrevocable. Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary. As such, there are no “stand-ready obligations” in any of the letters of credit issued by the Company and the contingent obligations are accounted for in accordance with SFAS 5, “Accounting for Contingencies”. At June 30, 2004 and 2003, the Company has recorded no liability for the current carrying amount of the obligation to perform as a guarantor, as such amounts are not considered material.


	24

At June 30, the Company’s total contractual amounts of commitments and letters of credit are as follows:

(dollars in thousands)		2004		2003

Legally binding commitments to extend credit:
Commercial and industrial	$	12,749	$	13,531
Residential real estate, including prime equity lines		18,999		15,790
Construction and development		14,519		17,347
Consumer and overdraft protection		2,152		2,367

		48,419		49,035
Standby letters of credit		2,786		3,718

Total commitments	$	51,205	$	52,753


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EFFECT OF INFLATION AND CHANGING PRICES

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America which require the measurement of financial position and results of operations in terms of historical dollars, without consideration of changes in the relative purchasing power over time due to inflation. Unlike most industries, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect in the financial institution’s performance than does the effect of inflation.

The yield on a majority of the Company’s earning assets adjusts simultaneously with changes in the short-term rates established by the Federal Reserve Board of Governors, specifically the discount rate, changes in which leads to a change in the prime lending rate. Given the Company’s asset-sensitive balance sheet position, assets reprice faster than liabilities, which generally results in decreases in net interest income during periods of declining interest rates. This may cause a decrease in the net interest margin until the fixed rate deposits mature and are repriced at lower current market rates, thus narrowing the difference between what the Company earns on its assets and what it pays on its liabilities. The opposite effect (that is, an increase in net interest income) is generally realized in a rising rate environment. The degree of interest rate sensitivity of the Company’s assets and liabilities and the differences in timing of repricing assets and liabilities provides an indication of the extent to which the Company’s net interest income may be affected by interest rate movements.

MARKET RISK AND ASSET-LIABILITY MANAGEMENT

The Company’s primary earnings source is its net interest income; therefore, the Company devotes significant time and has invested in resources to assist in the management of market risk. The Company’s net interest income is affected by changes in market interest rates, and by the level and composition of earning assets and interest-bearing liabilities. The Company’s objectives in its asset-liability management are to utilize its capital effectively, to provide adequate liquidity and enhance net interest income, without taking undue risks or subjecting the Company unduly to interest rate fluctuations. The Company takes a coordinated approach to the management of its capital, liquidity, and interest rate risk.

Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk inherent in its lending, investment, deposit, and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Other types of market risks, such as foreign currency exchange rate risk, and equity and commodity price risk, do not arise in the normal course of the Company’s business.


	26

Interest rate risk is the exposure to changes in market interest rates. The major source of the Company’s interest rate risk is the difference in the maturity and repricing characteristics between core banking assets and liabilities — loans and deposits. This difference, or mismatch, poses a risk to net interest income. The Company attempts to control the mix and maturities of assets and liabilities to maintain a reasonable balance between exposure to interest rate fluctuations and earnings and to achieve consistent growth in net interest income, while maintaining adequate liquidity and capital. A sudden and substantial increase or decrease in interest rates may adversely impact the Company’s earnings to the extent that the interest rates on earning assets and interest-bearing liabilities do not change at the same speed, to the same extent, or on the same basis.

The Company monitors the interest rate sensitivity of its balance sheet position and controls this risk by identifying and quantifying exposures in its near-term sensitivity through the use of simulation and valuation models, as well as its long-term gap position, reflecting the known or assumed maturity, repricing, and other cash flow characteristics of assets and liabilities. The Company’s simulation analysis involves dynamically modeling interest income and expense from current assets and liabilities over a specified time period under various interest rate scenarios and balance sheet structures, primarily to measure the sensitivity of net interest income over relatively short (e.g., less than 2-year) time horizons. As the future path of interest rates cannot be known in advance, management uses simulation analysis to project earnings under various interest rate scenarios in cluding reasonable or “most likely”, as well as deliberately extreme and perhaps unlikely, scenarios. Key assumptions in these simulation analyses relate to the behavior of interest rates and spreads, changes in the mix and volume of assets and liabilities, repricing and/or runoff of deposits, and, most importantly, the relative sensitivity of the Company’s assets and liabilities to changes in market interest rates. This relative sensitivity is important to consider as the Company’s core deposit base has not been subject to the same degree of interest rate sensitivity as its assets, the majority of which are based on external indices and change in concert with market interest rates. According to the model, the Company is presently positioned so that net interest income will increase in the short-term if interest rates rise and will decrease in the short-term if interest rates decline.

A traditional gap analysis is also prepared based on the maturity and repricing characteristics of earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on net interest income. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes in interest rates and other factors that could have an impact on interest rate sensitivity or net interest income, and is thus n ot, in management’s opinion, a true indicator of the Company’s interest rate sensitivity position.

The Company’s balance sheet structure is primarily short-term in nature with a substantial portion of assets and liabilities maturing within one year. The Company’s gap analysis indicates an asset-sensitive position over the entire lives of the assets and liabilities. For a 12 month period, the gap analysis indicates a slight negative (i.e. liability-sensitive) position as of June 30, 2004 of $2.6 million. However, when the “effective change ratio” (the historical relative movement of each asset’s and liability’s rates in relation to a 100 basis point change in the prime rate) is applied to the interest gap position, the Company is actually asset-sensitive over a 12 month period, as well as the entire repricing lives of the assets and liabilities. This is primarily due to the fact that in excess of 70% of the loan portfolio moves immediately on a one-t o-one ratio with a change in the prime lending rate, while the deposit rates do not increase or decrease as much or as quickly relative to a prime rate movement. The Company’s asset sensitive position means that assets reprice faster than the liabilities, which causes a decrease in the short-term in the net interest income and net interest margin in periods of declining rates until the fixed rate deposits mature and are repriced at then lower current market rates, thus narrowing the difference between what the Company earns on its assets and what it pays on its liabilities. Given the Company’s current balance sheet structure, the opposite effect (that is, an increase in net interest income and net interest margin) is realized in the short-term in a rising rate environment.

The Company monitors and considers methods of managing the rate sensitivity and repricing characteristics of the balance sheet components in order to minimize the impact of sudden and sustained changes in interest rates. Accordingly, the Company also performs a valuation analysis involving projecting future cash flows from current assets and liabilities to determine the Economic Value of Equity (“EVE”) which is the estimated net present value of those discounted cash flows. EVE represents the market value of equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for certain off-balance sheet items, over a range of assumed changes in market interest rates. The sensitivity of EVE to changes in the level of interest rates is a measure of the sensitivity of long-term earnings to changes in interest rates, and is used pri marily to measure the exposure of earnings and equity to changes in interest rates over a relatively long (e.g., greater than 2 years) time horizon.

The Company’s market risk exposure is measured using interest rate sensitivity analysis by computing estimated changes in EVE in the event of a range of assumed changes in market interest rates. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 - 300 basis points increase or decrease in the market interest rates. The Company’s Board of Directors has adopted an interest rate risk policy which establishes maximum allowable decreases in EVE in the event of a sudden and sustained increase or decrease in market interest rates.

At December 31, 2003, the Company’s estimated changes in EVE were within the limits established by the Board. As of June 30, 2004, there was no substantial change from the interest rate sensitivity analysis or the market value of portfolio equity for various changes in interest rates calculated as of December 31, 2003. The foregoing disclosures related to the market risk of the Company should be read in conjunction with the Company’s audited consolidated financial statements, related notes and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2003 included in the Company’s 2003 Annual Report on Form 10-K.

ACCOUNTING, REPORTING AND REGULATORY MATTERS

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses consolidation by business enterprises of variable interest entities. A revised version of FIN 46 was issued in December 2003. Under FIN 46, an enterprise that holds significant variable interest in a variable interest entity but is not the primary beneficiary is required to disclose the nature, purpose, size, and activities of the variable interest entity, its exposure to loss as a result of the variable interest holder’s involvement with the entity, and the nature of its involvement with the entity and date when the involvement began. The primary beneficiary of a variable interest entity is required to disclose the nature, purpose, size, and activities of the variable interest entit y, the carrying amount and classification of consolidated assets that are collateral for the variable interest entity’s obligations, and any lack of recourse by creditors (or beneficial interest holders) of a consolidated variable interest entity to the general credit of the primary beneficiary. The December 2003 revisions to FIN 46 clarify some requirements, addressed identification of variable interest entities, and add new scope exceptions. FIN 46 is effective for all entities that are not “special-purpose” (as defined) entities for the first fiscal year or interim period beginning after December 15, 2003. The unmodified provisions on FIN 46 must be applied to entities that are considered “special-purpose” entities by the end of the first reporting period ending after December 15, 2003. The adoption of FIN 46 did not have an impact on the Company.


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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See “Market Risk and Asset-Liability Management” in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations for quantitative and qualitative disclosures about market risk, which information is incorporated herein by reference.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

The Company’s principal executive officer and principal financial officer have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, (“the Exchange Act”) as of the end of the period covered by this report. Based upon this evaluation, the principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are designed and effective to provide reasonable assurance that information required to be disclosed by the Company in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and to provide reasonable assurance tha t information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

(b) Changes in Internal Controls

There was no significant change in the Company’s “internal control over financial reporting” (as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred during the last calendar quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.


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SUMMIT FINANCIAL CORPORATION

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings.
	The Corporation and its subsidiaries from time to time may be involved as plaintiff or defendant in various legal actions incident to its business. There are no material actions currently pending.

Item 2.	Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securitites.
	None.

Item 3.	Defaults Upon Senior Securities.
	None.

Item 4.	Results of Votes of Security Holders.
	At the Annual Meeting of Shareholders held April 20, 2004 pursuant to the Notice of Annual Meeting of Shareholders and Proxy Statement dated March 19, 2004, the following matters were voted on:
	*Election of four (4) nominees for director to 3-year terms*
	For the above matter, 3,811,009 shares (99.9% of the votes cast) voted FOR the election of the directors. No other matters were submitted to the shareholders for a vote at the Annual Meeting or at any other time during the quarter.

Item 5.	Other Information.
	None.

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

(a)	Exhibits:
31.1 -	Rule 13a – 14(a) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.
31.2 -	Rule 13a – 14(a) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002.
32.1 -	Section 1350 Certificate of Chief Executive Officer furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002.
32.2 -	Section 1350 Certificate of Chief Financial Officer furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002.

(b)	Reports on Form 8-K:
	On July 21, 2004, the Company filed a Form 8-K related to the earnings press release dated July 20, 2004, which included selected financial data for the three month and six month periods ended June 30, 2004 and for other selected periods.


	29

SUMMIT FINANCIAL CORPORATION

SIGNATURES

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

SUMMIT FINANCIAL CORPORATION

Date: July 28, 2004
	J. Randolph Potter, President and Chief Executive Officer

Date: July 28, 2004
	Blaise B. Bettendorf, Senior Vice President and Chief Financial Officer


	30

					FOR CAPITAL				TO BE CATEGORIZED
	ACTUAL				ADEQUACY PURPOSES				“WELL-CAPITALIZED”

		Amount	Ratio			Amount	Ratio			Amount	Ratio

As of June 30, 2004
THE COMPANY
Total capital to risk-weighted assets	$	37,826	14.96	%	$	20,221	8.00	%		N.A.
Tier 1 capital to risk-weighted assets	$	34,662	13.71	%	$	10,111	4.00	%		N.A.
Tier 1 capital to average assets	$	34,662	10.37	%	$	13,366	4.00	%		N.A.

THE BANK
Total capital to risk-weighted assets	$	32,481	13.00	%	$	19,990	8.00	%	$	24,988	10.00	%
Tier 1 capital to risk-weighted assets	$	29,355	11.75	%	$	9,995	4.00	%	$	14,993	6.00	%
Tier 1 capital to average assets	$	29,355	8.86	%	$	13,247	4.00	%	$	16,559	5.00	%

As of December 31, 2003
THE COMPANY
Total capital to risk-weighted assets	$	35,223	13.75	%	$	20,486	8.00	%		N.A.
Tier 1 capital to risk-weighted assets	$	32,019	12.50	%	$	10,243	4.00	%		N.A.
Tier 1 capital to average assets	$	32,019	9.92	%	$	12,911	4.00	%		N.A.

THE BANK
Total capital to risk-weighted assets	$	30,522	12.05	%	$	20,269	8.00	%	$	25,336	10.00	%
Tier 1 capital to risk-weighted assets	$	27,354	10.80	%	$	10,134	4.00	%	$	15,202	6.00	%
Tier 1 capital to average assets	$	27,354	8.57	%	$	12,772	4.00	%	$	15,965	5.00	%