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SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

For the fiscal year ended December 31, 2002

Commission File No. 0-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

201 Fifth Avenue SW, Olympia, Washington 98501

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code:  (360) 943-1500

Securities registered pursuant to Section 12(b) of the Act:  None

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

Common Stock, no par value per share

(Title of class)

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  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’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.    ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant is $113,314,991 and is based upon the last sales price as quoted on the NASDAQ Stock Market for March 5, 2003.

The Registrant had 6,687,291 shares of common stock outstanding as of March 5, 2003.

DOCUMENTS TO BE INCORPORATED BY REFERENCE

Portions of the Registrant’s definitive Proxy Statement dated March 21, 2003 for the 2003 Annual Meeting of Stockholders will be incorporated by reference into Part III of this Form 10-K.

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HERITAGE FINANCIAL CORPORATION

FORM 10-K

December 31, 2002

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PART I

ITEM 1.    BUSINESS

General

Heritage Financial Corporation is a bank holding company incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our reorganization from a mutual holding company form of organization to a stock holding company form of organization (“Conversion”).

We are primarily engaged in the business of planning, directing and coordinating the business activities of our wholly owned subsidiaries: Heritage Savings Bank (“Heritage Bank”) and Central Valley Bank, N.A. Heritage Bank is a Washington state-chartered savings bank whose deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) under the Savings Association Insurance Fund (“SAIF”). Heritage Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce, and Mason Counties. Central Valley Bank is a national bank whose deposits are insured by the FDIC under the Bank Insurance Fund (“BIF”). Central Valley Bank conducts business from its main office in Toppenish, Washington, and its five branch offices located in Yakima and Kittitas Counties.

Our business consists primarily of lending and deposit relationships with small businesses including agribusiness and their owners in our market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State. We also make residential construction, income property, and consumer loans.

On March 5, 1999, we merged with Washington Independent Bancshares, Inc. whose wholly owned subsidiary was Central Valley Bank. This merger was accounted for as a pooling of interests, and accordingly, our financial information has been restated to include the accounts and results of operations of Washington Independent Bancshares, Inc. for all periods presented. Effective June 12, 1998, we acquired North Pacific Bancorporation, whose wholly owned subsidiary was North Pacific Bank, in a transaction accounted for under purchase accounting rules. North Pacific Bank was a Washington state-chartered commercial bank, which was merged into Heritage Bank effective November 20, 1998.

Effective with the year ending December 31, 1998, we changed our fiscal year end from June 30th to December 31st. On December 31, 1998, we filed a Transition Report Form 10-K with the SEC reporting for the six month period ended December 31, 1998. This filing of Form 10-K for the fiscal year ended December 31, 2002 will be the fourth full twelve month period filed with a calendar year end. Throughout this report, every effort has been made to clarify the accounting period being referenced (i.e. six months ending December 31, 1998 or year ending June 30, 1998) and when appropriate year to year comparisons are made that reflect equivalent twelve month periods (i.e. twelve months ending December 31, 1998 to twelve months ending December 31, 1999).

Market Areas

We offer financial services to meet the needs of the communities we serve through community-oriented financial institutions. Headquartered in Olympia, Thurston County, Washington, we conduct business through Heritage Bank and Central Valley Bank. Heritage Bank has twelve full service offices, with six in Pierce County, five in Thurston County, and one in Mason County. Heritage Bank has one mortgage origination office, in Thurston County, which operates within a banking office. Central Valley Bank operates six full service offices, with five in Yakima County and one in Kittitas County.

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Olympia enjoys a stable economic climate, largely due to federal and state government employees and retired and active duty military personnel (Fort Lewis and McChord Air Force Base are both located in our primary market area). State government is by far the largest employer in Thurston County, employing over 20% of the total county work force. Federal, county, and municipal government together comprise nearly 31% of the county’s civilian employment base.

Thurston County has a population of 207,355 and grew at a rate of over 28% during the 1990’s according to the U.S. Census Bureau 2000 Census. Thurston County’s growth has been spurred by increased government employment and the expansion of a large retirement population, including many former military personnel.

Pierce County, where the City of Tacoma is located, has a population of 700,820 according to the U.S. Census Bureau 2000 Census. Its economy is well diversified, with the principal industries being aerospace, shipping, military-related government employment, agriculture, and forest products.

Mason County, which includes the City of Shelton, has a population of 49,405 according to the U.S. Census Bureau 2000 Census. The largest employer in the county is government, but its economy is substantially dependent upon the timber and forest products industries.

Yakima County is located in central Washington. It has a population of 222,581, according to the U.S. Census Bureau 2000 Census, and its economy is substantially dependent upon agriculture. Yakima County is a leading producer of tree fruits, hops, and other agricultural products.

Kittitas County is also located in central Washington and its county seat is the City of Ellensburg. The population of Kittitas County was 33,362 according to the U.S. Census Bureau 2000 Census. The county’s largest employer is government, and its economy is largely dependent upon agriculture.

Lending Activities

General.    Our lending activities are conducted through Heritage Bank and Central Valley Bank. We offer commercial, real estate, income property, agricultural, and consumer loans. We have focused on commercial lending in recent years, which reflects our efforts to broaden our products and services to those more closely related to commercial banking. As a result of a soft economy and low interest rates commercial loans decreased in the recent year to $243.9 million, or 51.9% of total loans, as of December 31, 2002 from $263.1 million, or 52.8% of total loans, as of December 31, 2001. We continue to provide real estate mortgages, both single and multifamily residential and commercial. Real estate mortgages decreased to $187.6 million, or 39.9% of total loans, at December 31, 2002, from $198.6 million, or 39.8% of total loans, at December 31, 2001. As we pursue our strategy to focus on commercial lending within a struggling economy, management continues to emphasize strong asset quality.

Our overall lending operations are guided by loan policies, which are reviewed and approved annually by our board of directors. These policies outline the basic policies and procedures by which lending operations are conducted. The policies address the types of loans, underwriting and collateral requirements, terms, interest rate and yield considerations, compliance with laws and regulations, and compliance with internal lending limits. We supplement our own supervision of the loan underwriting and approval process with periodic loan audits by experienced external loan specialists who review credit quality, loan documentation, and compliance with laws and regulations.

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The following table provides information about our loan portfolio by type of loan for the dates indicated. These balances are net of deferred loan fees and prior to deduction for the allowance for loan losses.

The following table presents at December 31, 2002 (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of fixed rate and variable or adjustable rate loans in the named categories that mature after one year.

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Real Estate Lending

One- to Four-Family Residential Real Estate Lending.    The majority of our residential loans are secured by one- to four-family residences located in our primary market area. Our underwriting standards require that one- to four-family portfolio loans generally are owner-occupied and do not exceed 80% (90% with private mortgage insurance) of the current appraised value or cost, whichever is lower, of the underlying collateral. Terms typically range from 15 to 30 years. We offer both fixed rate mortgages and adjustable rate mortgages (“ARMs”) with repricing based on a Treasury Bill or other index. However, our ability to generate volume in ARMs is largely a function of consumer preference and the interest rate environment. Our current policy is not to make ARMs with discounted initial interest rates (i.e., “teasers”). We generally sell all government guaranteed mortgages, both fixed rate and adjustable rate. Management determines to what extent we will retain or sell other ARMs and other fixed rate mortgages in their strategy to control our interest rate sensitivity position. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset/Liability Management”.

Multifamily and Commercial Real Estate Lending.    We have made, and anticipate continuing to make, on a selective basis, multifamily and commercial real estate loans in our primary market areas. Commercial real estate loans are made for small shopping centers, warehouses, and professional offices. Cash flow coverage to debt servicing requirements is generally 1.2 times or more. Our underwriting standards generally require that the loan-to-value ratio for multifamily and commercial real estate loans not exceed 80% of appraised value or cost, whichever is lower.

Multifamily and commercial real estate mortgage lending affords our banks an opportunity to receive interest at rates higher than those generally available from one-to four-family residential lending. However, loans secured by such properties usually are greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by multifamily and commercial real estate properties are often dependent on the successful operation and management of the properties, repayment of these loans may be affected by adverse conditions in the real estate market or the economy. We seek to minimize these risks by strictly scrutinizing the financial condition of the borrower, the quality of the collateral, and the management of the property securing the loan. We also generally obtain personal guarantees from financially capable borrowers based on a review of personal financial statements.

Construction Loans.    We originate one- to four-family residential construction loans for the construction of custom homes (where the home buyer is the borrower) and provide financing to builders for the construction of pre-sold homes and speculative residential construction (i.e. built before a buyer is identified). We lend to builders who have demonstrated a favorable record of performance and profitable operations and who are building in markets that management understands and is comfortable with existing economic conditions. We further endeavor to limit our construction lending risk through adherence to strict underwriting procedures. Loans to one builder are generally limited on a case-by-case basis with unsold home limits based on builder strengths. Our underwriting standards require that the loan-to-value ratio for pre-sold homes and speculative residential construction generally not exceed 80% of appraised value or builder’s cost less overhead, whichever is less. Speculative construction and land development loans are generally short term in nature and priced with a variable rate of interest using the prime rate as the index. We generally require builders to have some tangible form of equity in each construction project. Also, we generally require prompt and thorough documentation of all draw requests and use outside inspectors to inspect the project prior to paying any draw requests from builders.

Construction lending affords us the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does our single-family permanent mortgage lending. However, construction lending is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property’s value at completion of the project and the estimated costs of the project. As a result, these loans are generally more difficult to evaluate and monitor. If the estimate of

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construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, we may be confronted with a project whose value is insufficient to ensure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders, and the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the liquidation of the loan depends on the builder’s ability to sell the property.

Commercial Business Lending

We offer commercial loans to sole proprietorships, partnerships, and corporations with an emphasis on real estate related industries and businesses in agricultural, health care, legal, and other professions. The types of commercial loans offered are business lines of credit secured primarily by real estate, accounts receivable and inventory, business term loans secured by real estate for either working capital or lot acquisition, Small Business Administration (“SBA”) loans, and unsecured business loans.

Commercial business lending generally involves greater risk than residential mortgage lending and these risks differ from those associated with residential and commercial real estate lending. Commercial real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values, where liquidation of the underlying real estate collateral is viewed as the primary source of repayment if the borrower defaults. Although our commercial business loans are often collateralized by real estate, the decision to grant a commercial business loan depends primarily on the creditworthiness and cash flow of the borrower (and any guarantors), while liquidation of collateral is a secondary source of repayment.

As of December 31, 2002, we had $243.9 million, or 51.9% of our total loans receivable, in commercial loans. The average loan size is approximately $225,000 with loans generally in amounts of $500,000 or less.

Origination and Sales of Loans

We originate real estate and other loans with approximately two-thirds of the residential mortgage volumes generated from our mortgage loan origination office. Walk-in customers and referrals from real estate brokers are important sources of loan originations.

Consistent with our asset/liability management strategy, we sell a majority of our fixed rate and ARM residential mortgage loans to the secondary market. Commitments to sell mortgage loans generally are made during the period between the taking of the loan application and the closing of the mortgage loan. The timing for making these sale commitments is dependent upon the timing of the borrower’s election to lock-in the mortgage interest rate and fees prior to loan closing. Most of these sale commitments are made on a “best efforts” basis whereby we are only obligated to sell the mortgage if the mortgage loan is approved and closed. As a result, management believes that market risk is minimal. In addition, we have a small amount of mortgage loan production which is brokered to other lenders prior to funding.

When we sell mortgage loans, we typically sell the servicing of the loans (i.e., collection of principal and interest payments). However, we serviced $7.9 million, $6.3 million, and $3.9 million in mortgage loans for others as of December 31, 2000, 2001, and 2002, respectively. We received fee income for servicing activities on mortgage loans of $27,000, $22,000, and $19,000 for the years ended December 31, 2000, 2001, and 2002, respectively.

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The following table presents summary information concerning our origination and sale of residential mortgage loans and the gains achieved on such activities.

We have a minimal amount of purchased mortgage loans and mortgage loan participations.

Commitments and Contingent Liabilities

In the ordinary course of business, we enter into various types of transactions that include commitments to extend credit that are not included in our consolidated financial statements. We apply the same credit standards to these commitments as we use in all our lending activities and have included these commitments in our lending risk evaluations. Our exposure to credit loss under commitments to extend credit is represented by the amount of these commitments. At December 31, 2002, we had outstanding commitments to extend credit, including letters of credit, in the amount of $98 million.

Delinquencies and Nonperforming Assets

Delinquency Procedures.    We send a borrower a delinquency notice 15 days after the due date when the borrower fails to make a required payment on a loan, except for commercial loans. If the delinquency is not brought current by the 30th day, we mail a second notice and, if appropriate, call the borrower. Additional written and oral contacts are made with the borrower between 60 and 90 days after the due date.

If a real estate loan payment is past due for 45 days or more, loan servicing personnel perform an in-depth review of the loan status, the condition of the property, and the borrower’s financial circumstances. Based upon the results of our review, we may negotiate and accept a repayment program with the borrower, accept a voluntary deed in lieu of foreclosure or, when considered necessary, begin foreclosure proceedings. If foreclosed on, real property is sold at a public sale and we may bid on the property to protect our interest. A decision as to whether and when to begin foreclosure proceedings is based on such factors as the amount of the outstanding loan in relation to the value of the property securing the original indebtedness, the extent of the delinquency, and the borrower’s ability and willingness to cooperate in resolving the delinquency.

Real estate acquired by us is classified as real estate owned until it is sold. When property is acquired, it is recorded at the lower of cost or estimated fair value at the date of acquisition, not to exceed net realizable value, and any resulting write-down is charged to the allowance for loan losses. Upon acquisition, all costs incurred in maintaining the property are expensed. Costs relating to the development and improvement of the property, however, are capitalized to the extent of the property’s net realizable value.

We consider loans as an in-substance foreclosure if the borrower has little or no equity in the property based upon its estimated fair value, repayment can be expected only from operation or sale of the collateral, the borrower has effectively abandoned control of the collateral, or it is doubtful the borrower will be able to repay the loan in the foreseeable future because of the borrower’s current financial status. In substance foreclosures are accounted for as if the properties were held as other real estate.

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Delinquencies in the commercial business loan portfolio are handled on a case-by-case basis. Generally, notices are sent and personal contact is made with the borrower when the loan is 15 days past due. Loan officers are responsible for collecting loans they originate or which are assigned to them. Depending on the nature of the loan and the type of collateral securing the loan, we may negotiate and accept a modified payment program or take other actions as circumstances warrant.

Classification of Assets.    Federal regulations require that our banks periodically evaluate the risk inherent in their loan portfolio. In addition, Division of Banks of the Washington State Department of Financial Institutions (“Division”), the Office of the Comptroller of the Currency (“OCC”), and the FDIC have authority to identify problem assets and, if appropriate, require them to be classified by risk. There are three classifications for problem assets: Substandard, Doubtful, and Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values questionable. There is a high possibility of loss in assets classified as Doubtful. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or a portion of the asset is classified as Loss, the institution must charge off this amount.

Nonperforming Assets.    Nonperforming assets consist of nonaccrual loans, restructured loans, and real estate owned. The following table provides information about our nonaccrual loans, restructured loans, and real estate owned for the indicated dates.

Nonaccrual Loans.    Our financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on our loan portfolio, unless a loan is placed on nonaccrual. Loans are considered to be impaired and are placed on nonaccrual when there are serious doubts about the collectibility of principal or interest. Our policy is to place a loan on nonaccrual when the loan becomes past due for 90 days or more, is less than fully collateralized, and is not in the process of collection. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected.

Interest foregone (recovered) on nonaccrual loans was $129,612, $173,371 and ($29,986) for the years ended December 31, 2000, 2001, and 2002, respectively. Previous period interest foregone was immaterial.

Real estate owned at December 31, 2002 was $652,854 with $296,417 of this reported as a nonperforming asset. The difference is guaranteed by the Small Business Administration.

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Potential Problem Loans.    Potential problem loans are those loans which are currently accruing interest, but which are considered possible credit problems because financial information of the borrowers causes us concerns as to their ability to comply with the present repayment program and may result in placing the loan on nonaccrual. The increase of $6.6 million in potential problem loans from December 31, 2001 to December 31, 2002 is the result of a recent external credit review of Heritage Bank’s loan portfolio conducted at the request of management. The results of the credit review, while leading to an increase in our potential problem loans, provided us with a framework to improve our own internal credit review and approval processes. We are working with these borrowers to obtain appropriate information to properly evaluate and manage these loans.

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan and lease portfolio, including all binding commitments to lend. We determine an adequate allowance through our ongoing quarterly loan quality assessments.

We assess the estimated credit losses inherent in our non-classified loan portfolio by considering a number of elements including:

We calculate an adequate allowance for the non-classified portion of our loan portfolio based on an appropriate percentage risk factor that is calculated based on the above-noted elements and trends. We add specific provisions for each classified loan after a careful analysis of that loan’s credit and collateral factors. Our analysis of an adequate allowance combines the provisions made for both our non-classified loans and the specific provisions made for each classified loan.

We determine our provision expense for the next quarter by applying the same percentage risk factor applied to the non-classified loan portfolio to our expected loan growth. We determine our monthly provision expense by dividing our estimate of provision expense for the quarter by three.

Our historical loan loss experience remains low, even though we experienced higher loan losses in the last quarter of 2001 and during 2002 than in prior periods. We believe that it is appropriate, under current recessive conditions, to maintain a higher allowance for estimated credit losses, particularly with respect to our commercial loan portfolio, than our historical loan loss experience indicates.

We have increased our allowance for loan losses over the past several years during a period of strong loan growth and changes in our loan portfolio composition. Our commercial loan portfolio now makes up approximately half of our loan portfolio, while other less risky categories, such as the residential mortgage portfolio, have declined as a percentage of the total portfolio. We expect to continue to increase our allowance for loan losses because of the higher risk associated with commercial lending as experienced by the commercial banking industry.

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While we believe we use the best information available to determine the allowance for loan losses, net income could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance or unforeseen market conditions arise that cause adjustments to the allowance for loan losses.

The following table provides information regarding changes in our allowance for loan losses for the indicated periods:

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The following table shows the allocation of the allowance for loan losses for the indicated periods. The allocation is based upon an evaluation of defined loan problems, historical loan loss ratios, and industry wide and other factors that may affect future loan losses in the categories shown below:

Investment Activities

At December 31, 2002, our investment securities portfolio totaled $51.0 million, which consisted of $48.2 million of securities available for sale and $2.8 million of securities held to maturity. This compares with a total portfolio of $30.2 million at December 31, 2001, which was comprised of $26.5 million of securities available for sale and $3.7 million of securities held to maturity. The composition of the two investment portfolios by type of security, at each respective date, is presented in financial statement Notes 4 and 5.

Our investment policy is established by the board of directors and monitored by the Audit and Finance Committee. It is designed primarily to provide and maintain liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk, and complement our bank’s lending activities. The policy dictates the criteria for classifying securities as either available for sale or held for investment. The policy permits investment in various types of liquid assets permissible under applicable regulations, which include U.S. Treasury obligations, U.S. Government agency obligations, some certificates of deposit of insured banks, mortgage backed and mortgage related securities, some corporate notes, municipal bonds, FHLB stock, and federal funds. Investment in non-investment grade bonds, structured notes, and stripped mortgage backed securities are not permitted under the policy.

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The following table provides information regarding the carrying value, weighted average yields, and maturities or periods to repricing of our investment securities available for sale at December 31, 2002.

The following table provides information regarding the carrying value, weighted average yields, and maturities or periods to repricing of our investment securities held to maturity at December 31, 2002.