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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2003

OR

Commission File Number 0-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

(360) 943-1500

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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 the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:

As of July 15, 2003 there were 6,421,862 common shares outstanding, with no par value, of the registrant.

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

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

Page 2

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share data)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 3

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 4

HERITAGE FINANCIAL CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY FOR THE SIX MONTHS ENDED

JUNE 30, 2003 AND COMPREHENSIVE INCOME FOR THE THREE AND SIX MONTHS ENDED

JUNE 30, 2003 and 2002

(In Thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the six months ended June 30, 2003 and 2002

(Dollars in thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 6

HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three and Six Months Ended June 30, 2003 and 2002

(Unaudited)

NOTE 1. Description of Business and Basis of Presentation

(a.) Description of Business

Heritage Financial Corporation is a bank holding company that was 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.

We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly owned subsidiaries: Heritage Savings Bank and Central Valley Bank, N.A. Heritage Savings 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 Savings 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, N.A. is a national bank whose deposits are insured by the FDIC under the Bank Insurance Fund (BIF). Central Valley Bank, N.A. 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 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. We also make residential construction loans, income property loans, and consumer loans.

(b.) Basis of Presentation

The accompanying consolidated financial statements have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. These consolidated financial statements should be read with our December 31, 2002 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K. In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003. In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. Actual results could differ from those estimates.

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(c). Recently Issued Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board issued Financial Accounting Standard (FAS) No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123. This Statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results, as discussed in Note 3. The disclosure provisions of this statement were adopted in December 2002 and did not have a material effect on the results of our operations or financial position.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, addressing consolidation by business enterprises of certain variable interest entities. Under the provisions of Interpretation No. 46, an enterprise must consolidate a variable interest entity if that enterprise will absorb a majority of the entity’s expected losses or receive a majority of the entity’s residual returns, or both, regardless of the enterprise’s direct or indirect ability to make decisions about the entity’s activities through voting or similar rights. Interpretation No. 46 applies immediately to interests in variable interest entities created or acquired after January 31, 2003 and to the first fiscal year or interim period beginning after June 15, 2003 for interests in variable interest entities acquired before February 1, 2003. Application of this Interpretation did not have a material effect on our financial statements.

In April 2003, the Financial Accounting Standards Board issued Financial Accounting Standard (FAS) No. 149, Amendment of Statement 133 on Derivative instruments and Hedging Activities. The provisions of this Statement are effective for contracts entered into or modified after June 20, 2003 and hedging relationships designated after June 30, 2003. Except for the provisions related to FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, all provisions of this Statement should be applied prospectively. The provisions of the Statement related to Statement 133 Implementation Issues that have been effective for fiscal quarters that begin prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. We do not expect the adoption of the provisions of this Statement to have a material effect on the Company’s operating results or financial position.

In May 2003, the Financial Accounting Standards Board issued Financial Accounting Standard (FAS) 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. The provisions of this Statement are effective for financial instruments entered into or modified after May 31, 2003, and otherwise are effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in accounting principle for financial instruments created before May 15, 2003 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. We do not expect the adoption of the provisions of this Statement to have a material effect on the Company’s operating results or financial position.

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NOTE 2. Stockholders’ Equity

(a.) Earnings per Share

The following table illustrates the reconciliation of weighted average shares used for earnings per share for the noted periods.

As of June 30, 2003 and 2002, there were no anti-dilutive shares.

(b.) Cash Dividend Declared

On June 24, 2003, we announced a quarterly cash dividend of 14.0 cents per share payable on July 28, 2003 to stockholders of record on July 15, 2003.

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NOTE 3. Stock Based Compensation

The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-based Compensation. As most of the Company’s stock options have no intrinsic value at grant date, compensation cost generally has not been recognized for its stock option plan activity. However, compensation expense was recognized during 2002 and 2003 resulting from restricted stock awards and certain incentive stock options. If the Company had elected to recognize compensation cost on the fair value at the grant dates for awards under its plans, consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts for the following periods:

The compensation expense included in the pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year.

The fair value of options granted during the six months ended June 30, 2003 and 2002 is estimated on the date of grant using the Black-Scholes options pricing model. The following assumptions were used to calculate the fair value of the options granted:

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of the Company. The information contained in this section should be read with the unaudited condensed consolidated financial statements and its accompanying notes, and the December 31, 2002 audited consolidated financial statements and its accompanying notes included in our recent Annual Report on Form 10-K.

Statements concerning future performance, developments or events, expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and are subject to a number of risks and uncertainties, which might cause actual results to differ materially from stated expectations. Specific factors include, but are not limited to, the effect of interest rate changes, risks associated with acquisition of other banks and opening new branches, the ability to control costs and expenses, and general economic conditions. Additional information on these and other factors, which could affect our financial results, are included in our filings with the Securities and Exchange Commission.

Overview

In 1994, we began implementation of a growth strategy, which was intended to broaden our products and services from traditional thrift products and services to those more closely related to commercial banking. That strategy entails (1) geographic and product expansion, (2) loan portfolio diversification, (3) development of relationship banking, and (4) maintenance of asset quality. Effective January 8, 1998, we closed our second step conversion and stock offering, which resulted in $63 million in net proceeds. Thereafter, our common stock began to trade on the NASDAQ National Market under the symbol “HFWA”.

Financial Condition Data

Total assets decreased $6.9 million (1.2%) to $587.7 million as of June 30, 2003 from the December 31, 2002 balance of $594.6 million. Deposits decreased $8.7 million (1.7%) to $508.4 million as of June 30, 2003 from the December 31, 2002 balance of $517.1 million. For the same period, net loans, which include loans held for sale but are net of the allowance for loan losses, increased $20.4 million (4.4%) to $483.8 million as of June 30, 2003 from the December 31, 2002 balance of $463.4 million. The increase in loans is the result of new business beginning late in the first quarter and continuing through the second quarter, a trend that may or may not continue. However, we are encouraged by the current level of loan applications for both commercial real estate and business loans. Commercial loans continue to be the largest segment of loans at 54.3% and 51.9% as a percentage of all loans as of June 30, 2003 and December 31, 2002, respectively.

The Company’s stock repurchase program in the second quarter of 2003 continued to contribute to earnings per share. As of June 30, 2003, we have repurchased a total of 4,926,940 shares, or 45.4% of the total outstanding at March 1999, at an average price of $11.52 per share. During the quarter ended June 30, 2003, we repurchased 307,951 shares at an average price of $22.22. We began our current 10% repurchase program in mid-March 2003 with the goal to repurchase approximately 660,000 shares over a period of eighteen months. Through June 30, 2003, we purchased 324,649 shares under the current program at an average price of $22.16. We remain committed to repurchasing shares as long as equity ratios remain strong and the purchases are accretive to earnings per share.

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Earnings Summary

Net income for the three months ended June 30, 2003 was $0.32 per diluted share compared to $0.30 per diluted share for the same period last year. Actual earnings for the three months ended June 30, 2003 were $2,206,000 compared to $2,257,000 for the same period in 2002, a decrease of 2.3%. Net income for the six months ended June 30, 2003 was $0.62 per diluted share compared to $0.60 per diluted share for the same period last year. Actual earnings for the six months ended June 30, 2003 were $4,267,000 compared to $4,550,000 for the same period in 2002, a decrease of 6.2%. The difference in performance on a per share basis versus actual dollar basis is the result of our ongoing stock repurchase program that continues to be accretive to earnings per share. Average loans were $474.1 million for the quarter ended June 30, 2003 versus $474.9 million for the quarter ended June 30, 2002, a decline of 0.2%. Average loans were $465.8 million for the six months ended June 30, 2003 versus $477.4 million for the six months ended June 30, 2002, a decline of 2.4%. The decline in loans is a result of weakness in the western Washington economy over the past year.

Net Interest Income

Net interest income before provision for loan losses for the three months ended June 30, 2003 decreased 3.8% to $7,323,000 from $7,611,000 for the same quarter in 2002. Net interest income before provision for loan losses for the six months ended June 30, 2003 decreased 2.5% to $14,600,000 from $14,972,000 for the same period in 2002. The net interest margin (net interest income divided by average interest earning assets) decreased to 5.43% for the current quarter from 5.59% for the same quarter last year. The net interest margin decreased to $5.39% for the six months ended June 30, 2003 from 5.45% for the same period in 2002.

We have been able to maintain our favorable margin primarily by reducing the levels of our more expensive deposits and increasing the levels of our noninterest bearing deposits. Noninterest bearing deposits averaged $59.4 million for the quarter ended June 30, 2003 versus $54.1 million for the quarter ended June 30, 2002, an increase of 9.8%. Noninterest bearing deposits averaged $60.4 million for the six months ended June 30, 2003 versus $52.7 million for the six months ended June 30, 2002, an increase of 14.6%.

Interest income declined $1.0 million or 10.0% as compared to the second quarter last year and interest expense declined $737,000 or 28.2% during this same period. Interest income for the six months ended June 30, 2003 declined $2.05 million as compared to the same period last year and interest expense declined $1.68 million or 30.3% during this same period. Loans averaged $465.8 million with an average yield of 7.45% for the six months ended June 30, 2003 compared to average loans of $477.4 million with an average yield of 8.06% for the same period in 2002. Certificates of deposit averaged $203.1 million with an average cost of 2.56% for the six months ended June 30, 2003 compared to $231.8 million with an average cost of 3.24% for the same period in 2002.

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Provision for Loan Losses

The provision for loan losses was $330,00 for the three months ended June 30, 2003, down from $539,000 for the second quarter of 2002. The provision for loan losses was slightly down at $825,000 for the six months ended June 30, 2003 from $845,000 for the same period in 2002. We believe that the 2002 provisions were necessary to ensure that we maintain our allowance for loan losses at an adequate level given the increased risk in our portfolio that resulted from weak economic conditions. However, during the second quarter of 2003 our largest non-accruing loan re-paid and the anticipated additional losses on this credit were not realized.

Noninterest Income

Noninterest income increased 34.2% to $1,991,000 for the second quarter of 2003 compared with $1,484,000 for the same quarter in 2002. Noninterest income increased 25.8% to $3,617,000 for the six months ended June 30, 2003 from $2,876,000. The increase is the result of strong mortgage banking income, which was up 97.2% for the six months ended June 30, 2003 compared to the same period last year, and increased service charge and Merchant Visa income.

Noninterest Expense

Noninterest expense increased 9.0% to $5,608,000 during the second quarter of 2003 compared to $5,147,000 for the second quarter of 2002. Noninterest expense increased 7.1% to $10,857,000 for the six months ended June 30, 2003 from $10,133,000 for the same period last year. The majority of the increase occurred in salaries and employee benefits which were up 14.0% to $2,947,000 for the three months ended June 30, 2003 compared to the same period last year. Salaries and benefits increased 11.2% to $5,750,000 for the six months ended June 30, 2003 from $5,172,000 for the same period last year. Salaries were up over last year as a result of normal salary increases, increased commissions paid to our mortgage lenders, and expansion of our commercial lending staff in Pierce County. The efficiency ratio for the quarter ended June 30, 2003 was 60.21% compared to 56.59% for the comparable quarter in 2002. The efficiency ratio for the six months ended June 30, 2003 was 59.60% compared to 56.77% for the same period last year. The efficiency ratio increases are a result of reduced net interest income combined with growth in noninterest expense during the above mentioned periods.

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Lending Activities

Since initiating our expansion activities in 1994, we have supplemented our traditional mortgage loan products by increasing our emphasis on commercial loans. As indicated in the table below, total loans increased to $491.5 million at June 30, 2003 from $470.3 million at December 31, 2002.

Nonperforming Assets

The following table describes our nonperforming assets for the dates indicated.

Nonperforming assets decreased to $869,000, or 0.15% of total assets, at June 30, 2003 from $2,283,000, or 0.38% of total assets at December 31, 2002. We believe that we are adequately reserved for any potential losses.

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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 classified loans.

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, however, we believe that it is appropriate 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 periods of strong loan growth and changes in our loan portfolio composition. Our commercial loan portfolio has grown as a percentage of the total loan portfolio, while other less risky categories, such as the residential mortgage portfolio, have declined as a percentage of the total portfolio.

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.

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The following table summarizes the changes in our allowance for loan losses:

While pursuing our growth strategy, we continue to employ prudent underwriting and sound monitoring procedures to maintain asset quality. The allowance for loan losses during the six months ended June 30, 2003 increased by $792,000 to $7.67 million from $6.87 million at December 31, 2002. The growth in the allowance was due to an $825,000 provision, which was partially offset by $33,000 in net charge offs during the period. While pleased with the low level of charge offs in the first six months of this year, we cannot predict with any certainty the future level of charge offs. The continuation of a weak economy may result in additional charge offs.

Liquidity and Sources of Funds

Our primary sources of funds are customer deposits, public funds, loan repayments, loan sales, interest earned on and proceeds from investment securities, and advances from the FHLB of Seattle. These funds, together with retained earnings, equity, and other borrowed funds, are used to make loans, acquire investment securities and other assets, and fund continuing operations. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions, and competition.

We must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, satisfy other financial commitments, and fund operations.

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We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At June 30, 2003, cash and cash equivalents totaled $28.1 million, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $12.3 million, or 2.1% of total assets. At June 30, 2003, our banks maintained a credit facility with the FHLB of Seattle for $112.0 million, with $4.4 million in borrowings as of June 30, 2003.

Capital

Stockholders’ equity at June 30, 2003 was $64.7 million compared with $72.4 million at December 31, 2002. During the period, we repurchased $11.1 million of Heritage Financial Corporation stock, declared dividends of $1.8 million, realized income of $4.3 million, recorded $9,000 in unrealized gains on securities available for sale, and realized the effects of exercising stock options, earned ESOP and restricted stock shares totaling $929,000.

Banking regulations require bank holding companies and banks to maintain a minimum leverage ratio of core capital to adjusted quarterly average total assets of at least 3%. At June 30, 2003 our leverage ratio was 10.0% compared with 11.1% at December 31, 2002. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders’ equity, while Tier II capital includes the allowance for loan losses, subject to certain limitations. Regulatory minimum risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and total capital (combined Tier I and Tier II) of 8%. Our Tier I and total risk based capital ratios were 11.6% and 12.8%, respectively, at June 30, 2003 compared with 13.7% and 14.9%, respectively, at December 31, 2002.

During 1992, the FDIC published the qualifications necessary to be classified as a “well-capitalized” bank, primarily for assignment of FDIC insurance premium rates beginning in 1993. To qualify as “well-capitalized”, banks must have a Tier I risk based capital ratio of at least 6%, a total risk based capital ratio of at least 10%, and a leverage ratio of at least 5%. Heritage Bank and Central Valley Bank qualified as “well-capitalized” at June 30, 2003.

Quantitative and Qualitative Disclosures About Market Risk

Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. In our opinion, there has not been a material change in our interest rate risk exposure since our most recent year-end at December 31, 2002.

We do not maintain a trading account for any class of financial instrument nor do we engage in hedging activities or purchase high-risk derivative instruments. Moreover, we are not subject to foreign currency exchange rate risk or commodity price risk.

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Controls and Procedures

(a) Evaluation of disclosure controls and procedures. We maintain controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 are recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures, the Chief Executive and Chief Financial officers of the Company concluded that the Company’s disclosure controls and procedures were adequate.

(b) Changes in internal controls. We made no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation of those controls by the Chief Executive and Chief Financial officers.

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PART II. OTHER INFORMATION

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

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits