SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number 333-119800

FIRST STATE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:

(941) 929-9000

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $1.00 per share

(Title of Class)

     Check whether the issuer has (1) 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 issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

      Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of issuer’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     þ

      Indicate by check mark whether the issuer is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes o          No þ

      The aggregate market value of the Common Stock of the issuer held by non-affiliates of the issuer (1,841,734 shares) on June 30, 2004 was approximately $11,050,000. As of such date, no organized trading market existed for the Common Stock of the issuer. The aggregate market value was computed by reference to the last sale of the Common Stock of the issuer at $6.00 per share on June 22, 2004. For the purposes of this response, directors, officers and holders of 5% or more of the issuer’s Common Stock are considered the affiliates of the issuer at that date.

      As of February 28, 2005, there were issued and outstanding 5,856,265 shares of the issuer’s Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held on April 25, 2005 to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days of the issuer’s fiscal year end are incorporated into Part II, Item 9 and Part III items 10 through 14, of this Annual Report on Form 10-K.

TABLE OF CONTENTS

PART I

General

      First State Financial Corporation (“First State Financial”) was incorporated under the laws of the State of Florida on August 13, 1997. First State Financial is a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”) and owns all of the voting shares of First State Bank (“First State” or “First State Bank”). First State Bank is a state banking association.

      First State provides a range of consumer and commercial banking services to individuals, businesses and industries. The basic services offered by First State include: demand interest-bearing and noninterest-bearing accounts, money market deposit accounts, NOW accounts, time deposits, safe deposit services, credit cards, cash management, direct deposits, notary services, money orders, night depository, travelers’ checks, cashier’s checks, domestic collections, savings bonds, bank drafts, automated teller services, drive-in tellers, and banking by mail and the internet. In addition, First State primarily makes secured and unsecured commercial and real estate loans, residential, consumer and home equity loans, and issues stand-by letters of credit. First State provides debit cards, as a part of the STAR and Cirrus Networks, thereby permitting customers to utilize the convenience of larger ATM networks. In addition to the foregoing services, First State provides customers with extended banking hours. First State does not have trust powers and, accordingly, no trust services are provided.

      The revenues of First State are primarily derived from interest on, and fees received in connection with, real estate and other loans, and from interest and dividends from investment securities and short-term investments. The principal sources of funds for First State’s lending activities are its deposits, repayment of loans, and the maturity of investment securities. The principal expenses of First State are the interest paid on deposits, and operating and general administrative expenses.

      As is the case with banking institutions generally, First State’s operations are materially and significantly influenced by general economic conditions and by related monetary and fiscal policies of financial institution regulatory agencies, including the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Deposit flows and costs of funds are influenced by interest rates on competing investments and general market rates of interest. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. First State faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans. See “Competition.”

Special Note Regarding Forward-Looking Statements

      This Annual Report contains certain forward-looking statements which represent First State’s expectations or beliefs, including, but not limited to, statements concerning the banking industry and First State’s operations, performance, financial condition and growth. For this purpose, any statements contained in this Report that are not statements of historical fact may be deemed forward-looking statements. Without limiting the generality of the foregoing, words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,” “should,” “can,” “estimate,” or “continue” or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. These statements by their nature involve substantial risks and uncertainties, certain of which are beyond First State’s control, and actual results may differ materially depending on a variety of important factors, including competition, general economic conditions, changes in interest rates, and changes in the value of real estate and other collateral securing loans, among other things.

Lending Activities

      First State offers a range of lending services, including real estate, consumer and commercial loans, to individuals and small businesses and other organizations that are located in or conduct a substantial portion of their business in First State’s market area. First State’s consolidated net loans at December 31, 2004 and 2003 were $224.4 million, or 81.9% and $179.8 million or 84.7%, respectively, of total First State consolidated assets. The interest rates charged on loans vary with the degree of risk, maturity, and amount of the loan, and are further subject to competitive pressures, money market rates, availability of funds, and government regulations. First State has no foreign loans or loans for highly leveraged transactions.

      First State’s loans are segmented into four major areas: commercial and commercial real estate loans, construction loans, residential real estate loans, and consumer loans. A majority of First State’s loans are made on a secured basis. As of December 31, 2004, approximately 11.7% of First State’s consolidated loan portfolio consisted of loans secured by 1-4 family residential properties, compared to 11.8% at December 31, 2003.

      First State’s residential real estate loans generally are repayable in monthly installments based on up to a 30-year amortization schedule with variable interest rates.

      First State’s commercial, commercial real estate and construction loan portfolio includes loans to individuals and small-to-medium sized businesses located primarily in the West Central region of Florida for working capital, equipment purchases, and various other purposes. A majority of these loans are secured by real estate, equipment or similar assets. Construction loans typically carry a variable interest rate with a term of under two years, with interest payable monthly and principal due at maturity. Commercial lines of credit are typically granted on a demand basis, with annual reviews, loan covenants and monetary thresholds. Other commercial loans with terms or amortization schedules of longer than one year will normally carry interest rates which vary with market rates and generally reprice in three to five years. Commercial loans amounted to approximately 85.9% of First State’s total loan portfolio as of December 31, 2004, compared to 85.1% at December 31, 2003.

      First State’s consumer loan portfolio consists primarily of loans to individuals for various consumer purposes, but includes some business purpose loans which are payable on an installment basis. The majority of these loans are for terms of less than five years and are secured by liens on various personal assets of the borrowers, but consumer loans may also be made on an unsecured basis. Consumer loans are made at fixed and variable interest rates, and are often based on up to a five-year amortization schedule.

      For additional information regarding First State’s loan portfolio, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Lending Activities,” “— Classification of Assets,” and “— Loan Quality.”

      Loan originations are derived from a number of sources. Loan originations can be attributed to direct solicitation by First State’s loan officers, existing customers and borrowers, advertising, walk-in customers and, in some instances, referrals from brokers.

      Certain credit risks are inherent in making loans. These include prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. In particular, longer maturities increase the risk that economic conditions will change and adversely affect collectibility. First State attempts to minimize credit losses through various means. In particular, on larger credits, First State generally relies on the cash flow of a debtor as the source of repayment and secondarily on the value of the underlying collateral. In addition, First State attempts to utilize shorter loan terms in order to reduce the risk of a decline in the value of such collateral.

Deposit Activities

      Deposits are the major source of First State’s funds for lending and other investment activities. First State considers the majority of its regular savings, demand, NOW and money market deposit accounts to be core deposits. These accounts comprised approximately 39.2% and 33.8% of First State’s consolidated total deposits

at December 31, 2004 and 2003, respectively. Approximately 60.8% of First State’s consolidated deposits at December 31, 2004 were certificates of deposit compared to 66.2% at December 31, 2003. Generally, First State attempts to maintain the rates paid on its deposits at a competitive level. Time deposits of $100,000 and over made up approximately 14.9% and 15.2% of First State’s consolidated total deposits at December 31, 2004 and 2003, respectively. The majority of the deposits of First State are generated from the West Central region of Florida. First State does not currently accept brokered deposits. For additional information regarding First State’s deposit accounts, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Deposit Activities.”

Investments

      First State invests a portion of its assets in U.S. Government agency obligations, mortgage-backed securities, municipal securities and federal funds sold. First State’s investments are managed in relation to loan demand and deposit growth, and are generally used to provide for the investment of excess funds at minimal risks while providing liquidity to fund increases in loan demand or to offset fluctuations in deposits.

      With respect to First State’s investment portfolio, First State’s total portfolio may be invested in U.S. Treasury, general obligations of its agencies, and municipal securities, because such securities generally represent a minimal investment risk. In addition to the investment portfolio, First State may invest in federal funds sold. Federal funds sold is the excess cash First State has available over and above daily cash needs. This money is invested on an overnight basis with approved correspondent banks.

      First State monitors changes in financial markets. In addition to investments for its portfolio, First State monitors its daily cash position to ensure that all available funds earn interest at the earliest possible date. A portion of the investment account is designated as secondary reserves and invested in liquid securities that can be readily converted to cash with minimum risk of market loss. The remainder of the investment account may be placed in investment securities of different type and longer maturity. Daily surplus funds are sold in the federal funds market for one business day. First State attempts to stagger the maturities of its securities so as to produce a steady cash-flow in the event First State needs cash, or economic conditions change to a more favorable rate environment.

Correspondent Banking

      Correspondent banking involves one bank providing services to another bank which cannot provide that service for itself from an economic or practical standpoint. First State is required to purchase correspondent services offered by larger banks, including check collections, purchase of federal funds, security safekeeping, investment services, coin and currency supplies, overline and liquidity loan participations and sales of loans to or participation with correspondent banks.

      First State will sell loan participations to correspondent banks with respect to loans which exceed First State’s lending limit. Management of First State has established correspondent relationships with Independent Bankers’ Bank of Florida and SunTrust. First State pays for such services.

Data Processing

      First State outsources its data processing to a large bank data processor which provides a full range of data processing services, including an automated general ledger, deposit accounting, and commercial, mortgage and installment lending data processing.

Effect of Governmental Policies

      The earnings and business of First State are and will be affected by the policies of various regulatory authorities of the United States, especially the Federal Reserve. The Federal Reserve, among other things, regulates the supply of credit and deals with general economic conditions within the United States. The instruments of monetary policy employed by the Federal Reserve for these purposes influence in various ways

the overall level of investments, loans, other extensions of credit and deposits, and the interest rates paid on liabilities and received on assets.

Interest and Usury

      First State is subject to numerous state and federal statutes that affect the interest rates that may be charged on loans. These laws do not, under present market conditions, deter First State from continuing the process of originating loans.

Supervision and Regulation

      Banks and their holding companies, and many of their affiliates, are extensively regulated under both federal and state law. The following is a brief summary of certain statutes, rules, and regulations affecting First State Financial and First State Bank. This summary is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of First State Financial and First State Bank. Supervision, regulation, and examination of banks by regulatory agencies are intended primarily for the protection of depositors, rather than shareholders.

      Bank Holding Company Regulation. First State Financial is a bank holding company, registered with the Federal Reserve under the BHC Act. As such, First State Financial is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the Federal Reserve. The BHC Act requires that a bank holding company obtain the prior approval of the Federal Reserve before (i) acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank, (ii) taking any action that causes a bank to become a subsidiary of the bank holding company, or (iii) merging or consolidating with any other bank holding company.

      The BHC Act further provides that the Federal Reserve may not approve any transaction that would result in a monopoly or would be in furtherance of any combination or conspiracy to monopolize or attempt to monopolize the business of banking in any section of the United States, or the effect of which may be substantially to lessen competition or to tend to create a monopoly in any section of the country, or that in any other manner would be in restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the public interest in meeting the convenience and needs of the community to be served. The Federal Reserve is also required to consider the financial and managerial resources and future prospects of the bank holding companies and banks concerned and the convenience and needs of the community to be served. Consideration of financial resources generally focuses on capital adequacy and consideration of convenience and needs issues includes the parties’ performance under the Community Reinvestment Act of 1977 (the “CRA”), both of which are discussed below.

      Banks are subject to the provisions of the CRA. Under the terms of the CRA, the appropriate federal bank regulatory agency is required, in connection with its examination of a bank, to assess such bank’s record in meeting the credit needs of the community served by that bank, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the bank’s record is made available to the public. Further, such assessment is required of any bank which has applied to:

      In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application.

      The BHC Act generally prohibits a bank holding company from engaging in activities other than banking, or managing or controlling banks or other permissible subsidiaries, and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In determining whether a particular activity is permissible, the Federal Reserve must consider whether the performance of such an activity can reasonably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. For example, factoring accounts receivable, acquiring or servicing loans, leasing personal property, conducting securities brokerage activities, performing certain data processing services, acting as agent or broker in selling credit life insurance and certain other types of insurance in connection with credit transactions, and certain insurance underwriting activities have all been determined by regulations of the Federal Reserve to be permissible activities of bank holding companies. Despite prior approval, the Federal Reserve has the power to order a holding company or its subsidiaries to terminate any activity or terminate its ownership or control of any subsidiary, when it has reasonable cause to believe that continuation of such activity or such ownership or control constitutes a serious risk to the financial safety, soundness, or stability of any bank subsidiary of that bank holding company.

      Gramm-Leach-Bliley Act. Enacted in 1999, The Gramm-Leach-Bliley Act reforms and modernizes certain areas of financial services regulation. The law permits the creation of new financial services holding companies that can offer a full range of financial products under a regulatory structure based on the principle of functional regulation. The legislation eliminates the legal barriers to affiliations among banks and securities firms, insurance companies, and other financial services companies. The law also provides financial organizations with the opportunity to structure these new financial affiliations through a holding company structure or a financial subsidiary. The new law reserves the role of the Federal Reserve Board as the supervisor for bank holding companies. At the same time, the law also provides a system of functional regulation which is designed to utilize the various existing federal and state regulatory bodies.

      The law also includes a minimum federal standard of financial privacy. Financial institutions are required to have written privacy policies that must be disclosed to customers. The disclosure of a financial institution’s privacy policy must take place at the time a customer relationship is established and not less than annually during the continuation of the relationship. The act also provides for the functional regulation of bank securities activities. The law repeals the exemption that banks were afforded from the definition of “broker,” and replaces it with a set of limited exemptions that allow the continuation of some historical activities performed by banks. In addition, the act amends the securities laws to include banks within the general definition of dealer. Regarding new bank products, the law provides a procedure for handling products sold by banks that have securities elements. In the area of Community Reinvestment Act activities, the law generally requires that financial institutions address the credit needs of low-to-moderate income individuals and neighborhoods in the communities in which they operate. Bank regulators are required to take the Community Reinvestment Act ratings of a bank or of the bank subsidiaries of a holding company into account when acting upon certain branch and bank merger and acquisition applications filed by the institution. Under the law, financial holding companies and banks that desire to engage in new financial activities are required to have satisfactory or better Community Reinvestment Act ratings when they commence the new activity.

      Recent Legislation to Curtail Corporate Accounting Irregularities. On July 30, 2002, the Sarbanes-Oxley Act of 2002 (the “Sarbanes Act”) was enacted. The Securities and Exchange Commission (the “SEC”) has promulgated certain regulations pursuant to the Sarbanes Act and will continue to propose additional implementing or clarifying regulations as necessary in furtherance of the Sarbanes Act. The passage of the Sarbanes Act and the regulations implemented by the SEC subject publicly-traded companies to additional and more extensive reporting regulations and disclosure. Compliance with the Sarbanes Act and corresponding regulations may increase First State’s expenses.

      Bank Regulation. First State Bank is chartered under the laws of the State of Florida, and its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) to the extent provided by law. First State Bank is subject to comprehensive regulation, examination and supervision by the FDIC and the Florida Office of Financial Regulation (the “Florida OFR”) and to other laws and regulations applicable to banks. Such regulations include limitations on loans to a single borrower and to its directors, officers and employees; restrictions on the opening and closing of branch offices; the maintenance of required capital and liquidity ratios; the granting of credit under equal and fair conditions; and the disclosure of the costs and terms of such credit. First State Bank is examined periodically by the FDIC and the Florida OFR, to whom it submits periodic reports regarding its financial condition and other matters. The FDIC and the Florida OFR have a broad range of powers to enforce regulations under their jurisdiction, and to take discretionary actions determined to be for the protection and safety and soundness of banks, including the institution of cease and desist orders and the removal of directors and officers. The FDIC and the Florida OFR also have the authority to approve or disapprove mergers, consolidations, and similar corporate actions.

      There are various statutory limitations on the ability of First State to pay dividends. The FDIC and the Florida OFR also have the general authority to limit the dividend payment by banks if such payment may be deemed to constitute an unsafe and unsound practice. For information on the restrictions on the right of First State Bank to pay dividends to First State, see Part II — Item 5 “Market for the Registrant’s Common Equity and Related Stockholder Matters.”

      Under federal law, federally insured banks are subject, with certain exceptions, to certain restrictions on any extension of credit to their parent holding companies or other affiliates, on investment in the stock or other securities of affiliates, and on the taking of such stock or securities as collateral from any borrower. In addition, banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service.

      The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) imposed major regulatory reforms, stronger capital standards for savings and loan associations and stronger civil and criminal enforcement provisions. FIRREA also provides that a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with:

      The FDIC Improvement Act of 1991 (“FDICIA”) made a number of reforms addressing the safety and soundness of deposit insurance funds, supervision, accounting, and prompt regulatory action, and also implemented other regulatory improvements. Annual full-scope, on-site examinations are required of all insured depository institutions. The cost for conducting an examination of an institution may be assessed to that institution, with special consideration given to affiliates and any penalties imposed for failure to provide information requested. Insured state banks also are precluded from engaging as principal in any type of activity that is impermissible for a national bank, including activities relating to insurance and equity investments. The Act also recodified current law restricting extensions of credit to insiders under the Federal Reserve Act.

      Also important in terms of its effect on banks has been the deregulation of interest rates paid by banks on deposits and the types of deposit accounts that may be offered by banks. Most regulatory limits on permissible deposit interest rates and minimum deposit amounts expired several years ago. The effect of the deregulation of deposit interest rates generally has been to increase the costs of funds to banks and to make their costs of funds more sensitive to fluctuations in money market rates. A result of the pressure on banks interest margins due to deregulation has been a trend toward expansion of services offered by banks and an increase in the emphasis placed on fee or noninterest income.

      Capital Requirements. The Federal Reserve Board and bank regulatory agencies require bank holding companies and financial institutions to maintain capital at adequate levels based on a percentage of assets and off balance sheet exposures, adjusted for risk weights ranging from 0% to 100%. Under the risk-based standard, capital is classified into two tiers. Tier 1 capital consists of common shareholders’ equity, excluding

the unrealized gain (loss) on available-for-sale securities, minus certain intangible assets. Tier 2 capital consists of the general allowance for credit losses except for certain limitations. An institution’s qualifying capital base for purposes of its risk-based capital ratio consists of the sum of its Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% for Tier 1 and 8% for total risk-based capital. At December 31, 2004, First State Bank’s Tier 1 and total risk-based capital ratios were 18.0% and 19.2%, respectively.

      Bank holding companies and banks are also required to maintain capital at a minimum level based on total assets, which is known as the leverage ratio. The minimum requirement for the leverage ratio is 3%, but all but the highest rated institutions are required to maintain ratios 100 to 200 basis points above the minimum. At December 31, 2004, First State Bank’s leverage ratio was 16.5%.

      FDICIA contains “prompt corrective action” provisions pursuant to which banks are to be classified into one of five categories based upon capital adequacy, ranging from “well capitalized” to “critically undercapitalized” and which require (subject to certain exceptions) the appropriate federal banking agency to take prompt corrective action with respect to an institution which becomes “significantly undercapitalized” or “critically undercapitalized.”

      The FDIC has issued regulations to implement the “prompt corrective action” provisions of FDICIA. In general, the regulations define the five capital categories as follows:

      The FDIC also, after an opportunity for a hearing, has authority to downgrade an institution from “well capitalized” to “adequately capitalized” or to subject an “adequately capitalized” or “undercapitalized” institution to the supervisory actions applicable to the next lower category, for supervisory concerns.

      Generally, FDICIA requires that an “undercapitalized” institution must submit an acceptable capital restoration plan to the appropriate federal banking agency within 45 days after the institution becomes “undercapitalized” and the agency must take action on the plan within 60 days. The appropriate federal banking agency may not accept a capital restoration plan unless, among other requirements, each company having control of the institution has guaranteed that the institution will comply with the plan until the institution has been adequately capitalized on average during each of the three consecutive calendar quarters and has provided adequate assurances of performance. The aggregate liability under this provision of all companies having control of an institution is limited to the lesser of:

      An “undercapitalized” institution may not acquire an interest in any company or any other insured depository institution, establish or acquire additional branch offices or engage in any new business unless the appropriate federal banking agency has accepted its capital restoration plan, the institution is implementing the plan, and the agency determines that the proposed action is consistent with and will further the

achievement of the plan, or the appropriate Federal banking agency determines the proposed action will further the purpose of the “prompt corrective action” sections of FDICIA.

      If an institution is “critically undercapitalized,” it must comply with the restrictions described above. In addition, the appropriate Federal banking agency is authorized to restrict the activities of any “critically undercapitalized” institution and to prohibit such an institution, without the appropriate Federal banking agency’s prior written approval, from:

      The “prompt corrective action” provisions of FDICIA also provide that in general no institution may make a capital distribution if it would cause the institution to become “undercapitalized.” Capital distributions include cash (but not stock) dividends, stock purchases, redemptions, and other distributions of capital to the owners of an institution.

      Additionally, FDICIA requires, among other things, that:

      FDICIA also contains a number of consumer banking provisions, including disclosure requirements and substantive contractual limitations with respect to deposit accounts.

      As of December 31, 2004, First State Bank met the capital requirements of a “well capitalized” institution.

      The FDIC has proposed revising its risk-based capital requirements to ensure that such requirements provide for explicit consideration by commercial banks of interest rate risk. Under the proposed rule, a bank’s interest rate risk exposure would be quantified using either the measurement system set forth in the proposal or the bank’s internal model for measuring such exposure, if such model is determined to be adequate by the bank’s examiner. If the dollar amount of a bank’s interest rate risk exposure, as measured by either measurement system, exceeds 1% of the bank’s total assets, the bank would be required under the proposed rule to hold additional capital equal to the dollar amount of the excess. It is anticipated that the regulatory agencies will issue a revised proposed rule for further public comment. Pending issuance of such revised proposal, First State’s management cannot determine what effect, if any, an interest rate risk component would have on the capital of its subsidiary bank.

      Enforcement Powers. Congress has provided the federal bank regulatory agencies with an array of powers to enforce laws, rules, regulations and orders. Among other things, the agencies may require that institutions cease and desist from certain activities, may preclude persons from participating in the affairs of insured depository institutions, may suspend or remove deposit insurance, and may impose civil money penalties against institution-affiliated parties for certain violations.

      Maximum Legal Interest Rates. Like the laws of many states, Florida law contains provisions on interest rates that may be charged by banks and other lenders on certain types of loans. Numerous exceptions exist to the general interest limitations imposed by Florida law. The relative importance of these interest limitation laws to the financial operations of First State Bank will vary from time to time, depending on a number of

factors, including conditions in the money markets, the costs and availability of funds, and prevailing interest rates.

      Bank Branching. Banks in Florida are permitted to branch state wide. Such branch banking, however, is subject to prior approval by the FDIC and the Florida OFR. Any such approval would take into consideration several factors, including the bank’s level of capital, the prospects and economics of the proposed branch office, and other conditions deemed relevant by the FDIC and the Florida OFR for purposes of determining whether approval should be granted to open a branch office.

      Change of Control. Federal law restricts the amount of voting stock of a bank holding company and a bank that a person may acquire without the prior approval of banking regulators. The overall effect of such laws is to make it more difficult to acquire a bank holding company and a bank by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, shareholders of First State may be less likely to benefit from the rapid increases in stock prices that may result from tender offers or similar efforts to acquire control of other companies. Federal law also imposes restrictions on acquisitions of stock in a bank holding company and a state bank. Under the federal Change in Bank Control Act and the regulations thereunder, a person or group must give advance notice to the Federal Reserve before acquiring control of any bank holding company. Upon receipt of such notice, the Federal Reserve may approve or disapprove the acquisition. The Change in Bank Control Act creates a rebuttable presumption of control if a member or group acquires a certain percentage or more of a bank holding company’s or state bank’s voting stock, or if one or more other control factors set forth in the Act are present. Florida law also contains comparable provisions requiring persons to obtain Florida OFR approval prior to acquiring indirect control of the state bank through the acquisition of control of its bank holding company.

      Interstate Banking. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1996, provides for nationwide interstate banking and branching. Under the law, interstate acquisitions of banks or bank holding companies in any state by bank holding companies in any other state will be permissible one year after enactment. Interstate branching and consolidation of existing bank subsidiaries in different states is permissible. Florida has a law that allows out-of-state bank holding companies (located in states that allow Florida bank holding companies to acquire banks and bank holding companies in that state) to acquire Florida banks and Florida bank holding companies. The law essentially provides for out-of-state entry by acquisition only (and not by interstate branching) and requires the acquired Florida bank to have been in existence for at least three years.

      Effect of Governmental Policies. The earnings and businesses of First State Financial and First State Bank are affected by the policies of various regulatory authorities of the United States, especially the Federal Reserve. The Federal Reserve, among other things, regulates the supply of credit and deals with general economic conditions within the United States. The instruments of monetary policy employed by the Federal Reserve for those purposes influence in various ways the overall level of investments, loans, other extensions of credit, and deposits, and the interest rates paid on liabilities and received on assets.

Competition

      First State encounters strong competition both in making loans and in attracting deposits. The deregulation of the banking industry and the widespread enactment of state laws which permit multi-bank holding companies as well as an increasing level of interstate banking have created a highly competitive environment for commercial banking. In one or more aspects of its business, First State competes with other commercial banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Most of these competitors, some of which are affiliated with bank holding companies, have substantially greater resources and lending limits, and may offer certain services that First State does not currently provide. In addition, many of First State’s non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks. Recent federal and state legislation has heightened the competitive environment in which financial institutions must conduct their business, and the potential for competition among financial institutions of all types has increased significantly.

      To compete, First State relies upon specialized services, responsive handling of customer needs, and personal contacts by its officers, directors, and staff. Large multi-branch banking competitors tend to compete primarily by rate and the number and location of branches while smaller, independent financial institutions tend to compete primarily by rate and personal service.

Employees

      As of December 31, 2004, First State Financial and First State Bank collectively had 75 full-time employees (including executive officers) and 4 part-time employees. The employees are not represented by a collective bargaining unit. First State Financial and First State Bank consider relations with employees to be good.

Statistical Profile and Other Financial Data

      Reference is hereby made to the statistical and financial data contained in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for statistical and financial data providing a review of First State’s business activities.

      Executive and administrative offices of First State Financial and First State Bank are located at 22 South Links Avenue, Sarasota, Florida 34236 and consists of approximately 6,530 square feet on one floor, in the lobby, executive and customer service offices, teller stations, safe deposit booths, and related non-vault area and vault operations. A drive through facility and adequate paid parking also is on the premises. First State Bank owns the first floor of the building. The Bank also owns and operates the following branch offices: 5700 Clark Road, Sarasota, Florida 34233 (a one story building of approximately 4,737 square feet); 7555 Dr. Martin Luther King, Jr. Street North, St. Petersburg, Florida 33702 (a two story building of approximately 10,100 square feet); 2823 4th Street North, St. Petersburg, Florida 33704 (a one story building of approximately 2,100 square feet); and 7101 Park Street North, Seminole, Florida 33777 (a one story building of approximately 2,544 square feet). The Bank also leases a banking office at 2323 Stickney Point Road, Sarasota, Florida 34231. This branch consists of approximately 6,700 square feet and is leased for a period until May 31, 2007 (which includes renewal options).

      First State Financial and First State Bank are periodically parties to or otherwise involved in legal proceedings arising in the normal course of business, such as claims to enforce liens, claims involving the making and servicing of real property loans, and other issues incident to their respective businesses. Management does not believe that there is any pending or threatened proceeding against First State Financial or First State Bank which, if determined adversely, would have a material adverse effect on First State Financial’s consolidated financial position.

      No matters were submitted to a vote of First State Financial security holders during the fourth quarter of the year ended December 31, 2004.

PART II

      On December 9, 2004, First State Financial Common Stock was approved for listing on the Nasdaq National Market under the symbol FSTF. Prior to that time, there was no public market for the Common Stock. Management of First State Financial is aware of certain transactions in the common stock that occurred from January 1, 2002 through December 8, 2004, although the trading prices of all stock transactions

are not known. As to the shares of common stock traded since January 1, 2002, management is aware of the trading prices for the following transactions: in 2002, there was 18,907 shares traded at $5.00 per share in 29 transactions; in 2003, there were 255,963 shares traded in 19 transactions at prices ranging from $4.00 to $5.50 per share; and in 2004 through December 8, 2004, there were 340,382 shares in 62 transactions at prices ranging from $2.00 to $6.25 per share. Included in the 2004 activity was a private issuance of 300,000 shares at $6.25. Following the listing of our shares on the Nasdaq National Market on December 9, 2004 and through December 31, 2004, the high and low trading prices for the shares of common stock were $13.43 and $12.00, respectively.

      First State Financial had approximately 378 shareholders of record as of December 31, 2004.

Dividends

      First State Financial has not paid any cash dividends in the past. However, on February 16^th of 2005 the Board of Directors voted to declare a 5 cent dividend for holders of record on March 10, 2005, payable on March 31, 2005. If First State Financial’s Board determines to pay dividends in the future on the First State Financial Common Stock, the timing and the extent to which dividends are paid by First State Financial will be determined by such Board in light of then-existing circumstances, including First State Financial’s rate of growth, profitability, financial condition, existing and anticipated capital requirements, the amount of funds legally available for the payment of cash dividends, regulatory constraints and such other factors as the Board determines relevant. The source of funds for payment of dividends by First State Financial will be dividends received from First State Bank. Payments by First State Bank to First State Financial are limited by law and regulations of the bank regulatory authorities. There are various statutory and contractual limitations on the ability of First State Bank to pay dividends to First State Financial. The FDIC and the Florida OFR also have the general authority to limit the dividends paid by banks if such payment may be deemed to constitute an unsafe and unsound practice. Under Florida law, after making provisions for a reasonably anticipated future losses on loans and other assets, the board of directors of a bank may declare a dividend of so much of the bank’s aggregate net profits for the current year combined with its retained earnings (if any) for the preceding two years as the board deems appropriate and, with the approval of the Florida OFR, may declare a dividend from retained earnings for prior years. No dividends may be paid at a time when a bank’s net earnings from the preceding two years is a loss or which would cause the capital accounts of the bank to fall below the minimum amount required by law, regulation, order or any written agreement with the Florida OFR or a federal regulatory agency.

      Florida law applicable to companies (including First State Financial) provides that dividends may be declared and paid only if, after giving it effect, (i) the company is able to pay its debts as they become due in the usual course of business, and (ii) the company’s total assets would be greater than the sum of its total liabilities plus the amount that would be needed if the company were to be dissolved at the time of the dividend to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the dividend.

Share Repurchases

      The Company did not repurchase any shares of common stock in 2004.

      You should read the following selected consolidated financial data with our consolidated financial statements and notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Form 10-K. The results for past periods are not necessarily indicative of results that may be expected for any future period.

      Management’s discussion and analysis of operations and related financial data are presented herein to assist investors in understanding the financial condition of First State at, and results of operations of First State for the years ended, December 31, 2004, 2003 and 2002. This discussion should be read in conjunction with the consolidated financial statements and related footnotes of First State Financial presented elsewhere herein.

General

      First State Financial was incorporated in Florida on August 13, 1997 to serve as a holding company for First State Bank, which it acquired in 1998. In 2001, First State Bank and First State Bank of Pinellas, which was acquired by First State Financial in 1998, were merged. First State Bank is a full service commercial bank that offers a complete range of interest-bearing and non-interest bearing accounts, including commercial and retail checking accounts, money market accounts, individual retirement accounts, regular interest-bearing statement savings accounts, and certificates of deposit. Lending products include commercial loans, real estate loans, home equity loans and consumer/installment loans. In addition, First State Bank provides travelers’ checks, cashiers checks, safe deposit boxes, bank by mail services, direct deposit, on-line banking, and automated teller services. Specialized services to commercial customers include cash management, expanded on-line banking, lock box and door-to-door banking.

Overview

      Total assets at December 31, 2004 were $274.0 million compared to $212.3 million at December 31, 2003, an increase of $61.7 million, or 29.1%. The increase in total assets was primarily attributable to an increase in net loans receivable of $44.6 million, or 24.8%. The increase in loans was funded by the deposit growth experienced during the period, Federal Home Loan Bank advances, and proceeds from the issuance of common stock. The increase in net loans receivable consisted primarily of an increase in commercial real estate loans of $25.7 million, or 24.5%.

      Total deposits were $212.4 million at December 31, 2004 compared to $184.7 million at December 31, 2003, an increase of $27.7 million, or 15.0%. During this period, we experienced an increase in core deposit accounts of $20.9 million, or 33.4%, and time deposits of $6.8 million, or 5.6%. Consequently, the certificate of deposit portfolio as a percent of total deposits declined slightly to 60.8% at December 31, 2004 from 66.2% at December 31, 2003. Almost all certificates of deposit held by us mature in less than five years with approximately 40.9% maturing in the next year.

      For 2004, we recorded diluted earnings per share of 59 cents. This compares to diluted earnings per share of 26 cents for 2003, resulting in an increase in diluted earnings per share of 33 cents. Further, net interest margin increased by 16 basis points from 3.90% for 2003 to 4.06% for the current period. Management believes that if interest rates continue to increase, the net interest margin could be further positively impacted.

Critical Accounting Policies

      Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. The financial information contained within these statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have

already occurred. Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on our stated results of operations. In management’s opinion, our critical accounting policies deal with the following area: the establishment of our allowance for loan losses, as explained in detail in the “Loan Quality” and “Classification of Assets” sections of this discussion and analysis.

      Our allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, that management believes are appropriate at each reporting date. Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, loan concentrations and other factors. Qualitative factors include the general economic conditions in Florida, the effect of the 2004 hurricane season, size and complexity of individual credits in relation to loan structure, existing loan policies, and pace of portfolio growth. As we add new products and increase the complexity of our loan portfolio, we anticipate enhancing our methodology accordingly. Management may report a materially different amount for the provision for loan loss in the statement of operations to change the allowance for loan losses if its assessment of the above factors were different. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this Form 10-K as well as the portions of this discussion and analysis section entitled “Lending Activities,” “Loan Quality” and “Classification of Assets.” Although management believes the levels of the allowance as of December 31, 2004 were adequate to absorb probable losses inherent in the loan portfolio as of such date, a decline in local economic conditions, or other factors, could result in increasing losses that cannot be reasonably predicted at this time.

      This discussion presents management’s analysis of the financial condition and results of operations of First State Financial for each of the years ended December 31, 2004, 2003 and 2002, and includes the statistical disclosures required by the Securities and Exchange Commission Guide 3 (“Statistical Disclosure by Bank Holding Companies”). The discussion should be read in conjunction with the consolidated financial statements of First State Financial and the notes related thereto which appear elsewhere in this Form 10-K.

Results of Operations

      Net interest income increased to $9.0 million or by $2.2 million (up 32.8%) in 2004 compared to 2003. Net interest spread, the difference between the yield on earning assets and the rate paid on interest-bearing liabilities, was 3.71% in 2004, up 10 basis points from the average for 2003. The net interest margin was 4.06% for 2004, an increase of 16 basis points from the average for 2003.

      The following table represents for the twelve-month periods indicated, certain information related to our average balance sheet and our average yields on assets and average cost of liabilities. Such yields have been derived by dividing income or expenses by the average balance or the corresponding assets or liabilities. Average balances have been derived from daily averages.

      The effect of changes in average balances (volume) and rates on interest income, interest expense and net interest income, for the period indicated, is shown below. The effect of a change in average balance has been determined by applying the average rate in the earlier period to the change in the average balance of the later period, as compared with the earlier period. The effect of a change in the average rate has been determined by applying the average balance in the later period to the change in the average rate in the later period, as compared with the earlier period. Changes resulting from average balance/rate variances are allocated to the two categories based on the proportionate absolute changes in each category.

      The $2.2 million increase in 2004 in net interest income compared to 2003 and the $2.0 million increase in 2003 net interest income compared to 2002 reflect the impact of higher earning asset volumes and a stronger reduction in interest expense compared to interest income, resulting in an increased net interest spread.

Liquidity and Rate Sensitivity

      Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw their funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. In the ordinary course of business, our cash flows are generated from interest and fee income, as well as from loan repayments, the sale or maturity of investments available-for-sale, and the maturity of investment securities held-to-maturity. In addition to cash and due from banks, we consider all securities available-for-sale and federal funds sold as primary sources of asset liquidity. Many factors affect the ability to accomplish these liquidity objectives successfully, including the economic environment, the asset/liability mix within the balance sheet, as well as our reputation in the community. Our principal sources of funds are net increases in deposits, principal and interest payments on loans and proceeds from sales and maturities of investments. We use resources primarily to fund existing and continuing loan commitments and to purchase investment securities. At December 31, 2004 and December 31, 2003, we had commitments to originate loans totaling $30.6 million and $24.4 million, respectively, and had issued standby letters of credit of $277,000 and $138,000, respectively. Scheduled maturities of certificates of deposit during the twelve months following December 31, 2004 and December 31, 2003 totaled $52.8 million and $44.2 million, respectively. Management believes that at December 31, 2004 we had adequate resources to fund all our commitments, that substantially all of our existing commitments will be funded in the subsequent twelve months and, if so desired, that we can adjust the rates on certificates of deposit and other deposit accounts to retain deposits in a changing interest rate environment.

      Closely related to liquidity management is the management of interest-earning assets and interest-bearing liabilities. First State manages its rate sensitivity position to avoid wide swings in net interest margins and to minimize risk due to changes in interest rates.

      Our interest rate sensitivity position at December 31, 2004 is presented in the table below.

      Certain liabilities such as NOW and passbook savings accounts, while technically subject to immediate repricing in response to changing market rates, historically do not reprice as quickly nor to the extent as other interest-sensitive accounts. Nevertheless, if market interest rates should decrease, it is anticipated that our net interest margin would decrease due to many interest-bearing liabilities with current rates so low that further reductions could not be significant. Because of non-interest-bearing liabilities, total interest-earning assets are substantially greater than the total interest-bearing liabilities and therefore it is anticipated that over time the effects on net interest income from changes in asset yield will be greater than the change in expense from liability cost. Therefore, if rates increase it is anticipated that the net interest margin would over time increase and this is particularly true over longer time horizons since we have more total assets subject to rate changes than total liabilities that are rate sensitive.

      Interest-earning assets and time deposits are presented based on their contractual terms. It is anticipated that run off in any deposit category will be approximately offset by new deposit generation.

      Since we have experienced steady growth in deposits, no net run off in any deposit category is assumed in the interest rate sensitivity table. It is our policy to maintain our cumulative one year gap ratio in the 20% to (20)% range. At December 31, 2004, First State was within this range with a one year cumulative sensitivity ratio of 7.22%.

Capital Resources

      Our consolidated stockholders’ equity was $42.2 million at December 31, 2004, $11.1 million at December 31, 2003 and $10.5 million at December 31, 2002. The net increase in stockholders’ equity during 2004 consisted of net proceeds of $27.1 million from our public offering of common stock in the fourth quarter of 2004, $1.8 million from our private offering of common stock in early 2004, $65,000 from the exercise of options, $2.1 million from net income and an $8,000 increase in net unrealized loss on securities available-for-sale. The net increase in stockholders’ equity during 2003 consisted of $795,000 from net income and a $229,000 increase in net unrealized loss on securities available-for-sale. Our total stockholders’ equity was 15.4%, 5.2% and 6.9% of total assets as of December 31, 2004, 2003 and 2002, respectively. Our average equity to average assets for the years 2004, 2003, and 2002, was 6.1%, 5.9% and 6.6%, respectively.

      The federal banking regulatory authorities have adopted certain “prompt corrective action” rules with respect to depository institutions. The rules establish five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” The various federal banking regulatory agencies have adopted regulations to implement the capital rules by, among other things, defining the relevant capital measures for the five capital categories. An institution is deemed to be “well capitalized” if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater and is not subject to a regulatory order, agreement, or directive to meet and maintain a specific capital level. Depository institutions which fall below the “adequately capitalized” category generally are prohibited from making any capital distribution, are subject to growth limitations, and are required to submit a capital restoration plan. There are a number of requirements and restrictions that may be imposed on institutions treated as “significantly undercapitalized” and, if the institution is “critically undercapitalized,” the banking regulatory agencies have the right to appoint a receiver or conservator. At December 31, 2004, the Bank met the capital ratios of a “well-capitalized” financial institution with a total risk-based capital ratio of 19.2%, a Tier 1 risk-based capital ratio of 18.0%, and Tier 1 leverage ratio of 16.5%.

      In accordance with risk-based capital guidelines issued by the Federal Reserve Board and the FDIC, we are required to maintain a minimum standard of total capital to risk-weighted assets of 8%. Additionally, the FDIC requires banks to maintain a minimum leverage-capital ratio of Tier 1 capital (as defined) to total assets. The leverage-capital ratio ranges from 3% to 5% based on our rating under the regulatory rating system. The required leverage-capital ratio for us at December 31, 2004 and December 31, 2003 was 4%. The following table summarizes our capital ratios at the dates indicated, as well as those required to be maintained by an adequately-capitalized financial institution:

Lending Activities

      A significant source of our income is the interest earned on the loan portfolio. At December 31, 2004, our total assets were $274.0 million and loans receivable, net were $224.4 million or 81.9% of total assets. At December 31, 2003, our total assets were $212.3 million and loans receivable, net were $179.8 million or 84.7% of total assets. At December 31, 2002, our total assets were $153.5 million and our loans receivable, net were $120.1 million or 78.3% of total assets. The increase in net loans receivable from December 2003 to December 31, 2004 was $44.6 million or 24.8%, and from December 31, 2002 to December 31, 2003 was $59.7 million or 49.7%.

      Our primary market area consists of the West Central Florida region. Our market area’s economic base is diversified. Significant industries include hospitality and tourism, service enterprises, technology and information concerns, agribusiness and manufacturing. The area has experienced considerable growth over the past several years. However, there is no assurance that this area will continue to experience economic growth. Adverse conditions in any one or more of the industries operating in such markets or a slow-down in general economic conditions could have an adverse effect on us.

      Lending activities are conducted pursuant to a written policy which has been adopted by us. Each loan officer has defined lending authority beyond which loans, depending upon their type and size, must be reviewed and approved by a loan committee comprised of certain officers and directors. Under Florida law, our Bank can lend to any one person up to 15% of our capital on an unsecured basis, and an additional 10% on a secured basis. As of December 31, 2004, our largest credit relationship, which did not exceed these limitations, was $3.9 million, or 9.2% of total capital.

      At December 31, 2004, 2003, 2002, 2001 and 2000, the composition of our loan portfolio was as follows:

      The contractual maturity distribution of our loan portfolio at December 31, 2004 is indicated in the table below. The majority of these are amortizing loans.

Loan Quality

      Management seeks to maintain a high quality of loans through sound underwriting and lending practices. As of December 31, 2004, 2003 and 2002 approximately 82.1%, 79.5% and 75.3%, respectively, of the total loan portfolio was collateralized by commercial and residential real estate mortgages. The level of nonperforming loans also is relevant to the credit quality of a loan portfolio. As of December 31, 2004, 2003 and 2002, total nonperforming loans (those 90 days or more past due) totaled $803,000 or .4%, $1.2 million or .7%, and $1.2 million or 1.0% of total loans, respectively. There was no other real estate owned at December 31, 2004 or 2003.

      The commercial real estate mortgage loans in our portfolio consist of fixed- and adjustable-interest rate loans which were originated at prevailing market interest rates. Our policy has been to originate commercial real estate mortgage loans predominantly in our primary market area. Commercial real estate mortgage loans are generally made in amounts up to 80% of the appraised value of the property securing the loan and entail significant additional risks compared to residential mortgage loans. In making commercial real estate loans, we primarily consider the net operating income generated by the real estate to support the debt service, the

financial resources and income level and managerial expertise of the borrower, the marketability of the collateral and our lending experience with the borrower.

      Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his employment and other income and which are collateralized by real property whose value tends to be more readily ascertainable, commercial loans typically are underwritten on the basis of the borrower’s ability to make repayment from the cash flow of his business and generally are collateralized by business assets, such as accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial loans may be substantially dependent on the success of the business itself, which is subject to adverse conditions in the economy. Commercial loans also entail certain additional risks since they usually involve large loan balances to single borrowers or a related group of borrowers, resulting in a more concentrated loan portfolio. Further, the collateral underlying the loans may depreciate over time, cannot be appraised with as much precision as residential real estate, and may fluctuate in value based on the success of the business.

      We make consumer and personal loans on a collateralized and noncollateralized basis. These loans are often collateralized by automobiles, recreational vehicles and mobile homes. Our policy is not to advance more than 80% of collateral value and that the borrower have established over one year of residence and demonstrated an ability to repay a similar debt according to credit bureau reports. Consumer and personal loans also are generated. Such loans generally have a term of 120 months or less.

      From time to time, we will originate loans on an unsecured basis. At December 31, 2004, 2003 and 2002, unsecured loans totaled $2.5 million, $2.3 million and $2.9 million, respectively.

      Loan concentrations are defined as amounts loaned to a number of borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions. As of December 31, 2004, 2003 and 2002, no concentration of loans within any portfolio category to any group of borrowers engaged in similar activities or in a similar business exceeded 20% of total loans, except that as of such dates loans collateralized with mortgages on real estate represented 82.1%, 79.5% and 75.3%, respectively, of the loan portfolio and were to borrowers in varying activities and businesses.

      The Loan Committee of the Board of Directors concentrates its efforts and resources, and that of its senior management and lending officers, on loan review and underwriting procedures. Internal controls include ongoing reviews of loans made to monitor documentation and the existence and valuations of collateral. In addition, management has established a review process with the objective of identifying, evaluating, and initiating necessary corrective action for marginal loans. The goal of the loan review process is to address classified and nonperforming loans as early as possible.

Classification of Assets

      Generally, interest on loans accrues and is credited to income based upon the principal balance outstanding. It is management’s policy to discontinue the accrual of interest income and classify a loan as non-accrual when principal or interest is past due 90 days or more unless, in the determination of management, the principal and interest on the loan are well collateralized and in the process of collection. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal and interest is considered doubtful. Loans are not returned to accrual status until principal and interest payments are brought current and future payments appear reasonably certain. Interest accrued and unpaid at the time a loan is placed on nonaccrual status is charged against interest income.

      Real estate acquired by us as a result of foreclosure or by deed in lieu of foreclosure is classified as other real estate owned (“OREO”). OREO properties are recorded at the lower of cost or fair value less estimated selling costs, and the estimated loss, if any, is charged to the allowance for credit losses at the time it is transferred to OREO. Further write-downs in OREO are recorded at the time management believes additional deterioration in value has occurred and are charged to noninterest expense.

      We account for impaired loans under Statements of Financial Accounting Standards No. 114 and 118. These Statements address the accounting by creditors for impairment of certain loans and generally require us

to identify loans, for which we probably will not receive full repayment of principal and interest, as impaired loans. The Statements require that impaired loans be valued at the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the observable market price of the loan, or the fair value of the underlying collateral if the loan is collateral dependent. We have implemented the Statements by modifying our monthly review of the adequacy of the allowance for credit losses to also identify and value impaired loans in accordance with guidance in the Statements.

      As of the dates indicated, loans on non-accrual status and other real estate owned and certain other related information were as follows:

      The gross interest income that would have been recorded for 2004, if the above nonperforming loans had been current in accordance with their original terms totaled $70,000. The amount of interest income on those loans that was included in net income for the period was approximately $4,000.

      In addition to the nonperforming loans identified above, First State has identified $2 million of additional problem loans at December 31, 2004.

      As of December 31, 2004, non-accrual loans totaled $803,000. This figure was comprised of four customer relationships. The largest customer relationship represents $729,000 or 90.8% of nonaccrual loans. The relationship consisted of seven commercial real estate investment properties with a chronic delinquency history and borrower/guarantor in bankruptcy.

      Monthly, management evaluates the collectibility of its nonperforming loans and the adequacy of its allowance for loan losses to absorb the identified and unidentified losses inherent in the loan portfolio. As a result of these evaluations, loans considered uncollectible are charged-off and adjustments to the reserve considered necessary are provided through a provision charged against earnings. These evaluations consider the current economic environment, the real estate market and its impact on underlying collateral values, trends in the level of nonperforming and past-due loans, and changes in the size and composition of the loan portfolio.

      The allowance for loan losses totaled approximately $2.7 million, $2.3 million and $1.7 million at December 31, 2004, 2003 and 2002, respectively. As of December 31, 2004 net loans charged-off totaled $334,000. The years ended December 31, 2003 and 2002 had net loans charged-off of $468,000 and $107,000, respectively. At December 31, 2004, 2003 and 2002, nonperforming loans totaled $803,000, $1.2 million and $1.2 million respectively, or 0.4%, 0.7% and 1.0%, respectively, of total loans outstanding. Considering the nature of our loan portfolio, management believes that the allowance for credit losses at December 31, 2004 was adequate.

      During the years ended December 31, 2004, 2003, 2002, 2001 and 2000, the activity in our allowance for credit losses was as follows:

      The following table represents management’s best estimate of the allocation of the allowance for loan losses to the various segments of the loan portfolio based on information available as of the dates indicated. Due to the ongoing evaluation and changes in the basis for the allowance for loans losses, actual future charge offs will not necessarily follow the allocations described below.

      The make-up of our loan portfolio as expressed as a percentage of loans to total loans at December 31, 2004 only changed slightly from that at December 31, 2003. However, the methodology of the allocation for loan losses was changed to more accurately reflect its unallocated portion of the reserve and assign it to the appropriate loan types. Management believes the overall quality of First State’s loan portfolio at December 31, 2004 is consistent with that at December 31, 2003 as evidenced by the consistency of the overall allowance for loan losses as a percentage of total loans.

Investment Securities

      The following table sets forth of our investment portfolio as of December 31, 2004, 2003 and 2002: