VIRGINIA FINANCIAL GROUP INC - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 000-22283

Virginia Financial Group, Inc.

(Exact name of registrant as specified in its charter)

Virginia

54-1829288

(State or other jurisdiction of

Incorporation or organization)

(I.R.S. Employer

Identification No.)


102 South Main Street, Culpeper, Virginia		22701
(Address of principal executive offices)		(Zip Code)

(Registrant’s telephone number, including area code) 540-829-1633

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 report(s), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.

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

As of October 30, 2004, there were 7,160,417 shares of common stock, $5.00 par value, issued and outstanding.

VIRGINIA FINANCIAL GROUP, INC.

INDEX


		Page No.
PART I - FINANCIAL INFORMATION

ITEM 1	Consolidated Financial Statements:

	Consolidated Balance Sheets	3

	Consolidated Statements of Income	4-5

	Consolidated Statements of Changes in Stockholders’ Equity	6

	Consolidated Statements of Cash Flows	7-8

	Notes to Consolidated Financial Statements	9-15

ITEM 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16-25

ITEM 3	Quantitative and Qualitative Disclosures About Market Risk	26

ITEM 4	Controls and Procedures	26

PART II - OTHER INFORMATION

ITEM 1	Legal Proceedings	26

ITEM 2	Unregistered Sales of Equity Securities and Use of Proceeds	26

ITEM 3	Defaults Upon Senior Securities	27

ITEM 4	Submission of Matters to a Vote of Security Holders	27

ITEM 5	Other Information	27

ITEM 6	Exhibits	27

PART I – FINANCIAL INFORMATION

ITEM 1. Financial statements

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(000 OMITTED)


	SEPTEMBER 30, 2004		DECEMBER 31, 2003
	(unaudited)
ASSETS
Cash and due from depository institutions	$	49,135	$	43,719
Federal funds sold		3,395		1,222
Interest-bearing deposits in banks		132		237
Securities (market value: 2004, $298,349; 2003, $364,926)		297,942		364,298
Loans held for sale		5,924		5,174
Loans receivable, net		1,022,208		912,946
Bank premises and equipment, net		26,748		27,311
Interest receivable		5,669		5,914
Other real estate owned		5		454
Core deposit intangibles, net		5,726		6,247
Goodwill		14,033		14,033
Other assets		8,839		5,656

Total Assets	$	1,439,756	$	1,387,211

LIABILITIES
Deposits:
Noninterest-bearing demand deposits	$	220,355	$	216,560
Interest-bearing deposits		1,030,366		994,214

Total deposits		1,250,721		1,210,774

Federal funds purchased and securities sold under agreements to repurchase		20,160		33,155
Short-term borrowings		240		6,526
Federal Home Loan Bank advances		14,080		9,140
Trust preferred capital notes		20,000		—
Interest payable		2,135		2,223
Other liabilities		6,741		5,563
Commitments and contingencies		—		—

Total Liabilities		1,314,077		1,267,381

STOCKHOLDERS’ EQUITY
Preferred stock, no par value; (Authorized 5,000,000 shares, no shares outstanding)		—		—
Common stock, par value $5.00 per share; (Authorized 25,000,000 shares; issued and outstanding 7,160,417 and 7,149,926 respectively)		35,802		35,764
Capital surplus		7,742		7,578
Retained earnings		79,232		72,255
Accumulated other comprehensive income, net		2,903		4,233

Total Stockholders’ Equity		125,679		119,830

Total Liabilities and Stockholders’ Equity	$	1,439,756	$	1,387,211

See accompanying notes to consolidated financial statements.

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(000 OMITTED)


	THREE MONTHS ENDED SEPTEMBER 30,
	2004		2003
	(unaudited)		(unaudited)
Interest Income
Interest and fees on loans	$	14,969	$	12,167
Interest on deposits in other banks		1		29
Interest on investment securities:
Taxable		92		109
Interest and dividends on securities available for sale:
Taxable		2,023		2,066
Nontaxable		696		897
Dividends		132		96
Interest income on federal funds sold		23		25

Total Interest Income		17,936		15,389

Interest Expense
Interest on deposits		4,322		4,396
Interest on Federal Home Loan Bank advances		181		163
Interest on federal funds purchased and securities sold under agreements to repurchase		47		62
Interest on other short-term borrowings		5		1
Interest on trust preferred capital notes		220		—

Total Interest Expense		4,775		4,622

Net Interest Income		13,161		10,767
Less: Provision for loan losses		636		323

Net Interest Income after Provision for Loan Losses		12,525		10,444
Noninterest Income
Retail banking fees		2,011		1,455
Fees from fiduciary activities		676		673
Mortgage banking fees		534		1,288
Brokerage services		169		103
Other operating income		252		272
Gains on securities available for sale		—		365
Gains on other real estate owned		—		20

Total Noninterest Income		3,642		4,176

Noninterest Expense
Compensation and employee benefits		5,793		5,690
Net occupancy expense		697		561
Supplies and equipment		1,085		893
Amortization-intangible assets		173		39
Computer services		350		270
Telecommunications		227		184
Marketing		165		169
Capital stock taxes		145		193
Professional fees		162		219
Other operating expenses		1,636		1,689

Total Noninterest Expense		10,433		9,907

Income Before Income Tax Expense		5,734		4,713
Income tax expense		1,743		1,181

Net Income	$	3,991	$	3,532

Earnings per Share, basic	$	.56	$	.49

Earnings per Share, diluted	$	.55	$	.49

See accompanying notes to consolidated financial statements.

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(000 OMITTED)


	NINE MONTHS ENDED SEPTEMBER 30,
	2004		2003
	(unaudited)		(unaudited)
Interest Income
Interest and fees on loans	$	43,263	$	36,381
Interest on deposits in other banks		3		31
Interest on investment securities:
Taxable		279		337
Interest and dividends on securities available for sale:
Taxable		6,580		5,956
Nontaxable		2,158		2,731
Dividends		256		259
Interest income on federal funds sold		32		169

Total Interest Income		52,571		45,864

Interest Expense
Interest on deposits		13,093		13,681
Interest on Federal Home Loan Bank advances		519		533
Interest on federal funds purchased and securities sold under agreements to repurchase		161		159
Interest on other short-term borrowings		141		4
Interest on trust preferred capital notes		442		—

Total Interest Expense		14,356		14,377

Net Interest Income		38,215		31,487
Less: Provision for loan losses		1,953		968

Net Interest Income after Provision for Loan Losses		36,262		30,519
Noninterest Income
Retail banking fees		5,610		4,143
Fees from fiduciary activities		2,136		2,162
Mortgage banking fees		2,015		3,610
Brokerage services		514		451
Other operating income		773		884
Gains on securities available for sale		—		435
Gains on other real estate owned		—		20

Total Noninterest Income		11,048		11,705

Noninterest Expense
Compensation and employee benefits		17,601		16,274
Net occupancy expense		2,073		1,679
Supplies and equipment		3,224		2,840
Amortization-intangible assets		520		118
Computer services		1,091		902
Telecommunications		794		567
Marketing		467		479
Capital stock taxes		455		578
Professional fees		653		575
Other operating expenses		4,624		4,240

Total Noninterest Expense		31,502		28,252

Income Before Income Tax Expense		15,808		13,972
Income tax expense		4,677		3,557

Net Income	$	11,131	$	10,415

Earnings per Share, basic	$	1.56	$	1.46

Earnings per Share, diluted	$	1.55	$	1.45

See accompanying notes to consolidated financial statements.

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

(000 OMITTED)

(unaudited)


	Common Stock			Capital Surplus			Accumulated Other Comprehensive Income			Retained Earnings			Comprehensive Income			Total
Balance, January 1, 2003	$	35,884		$	8,143		$	6,210		$	64,134					$	114,371
Net income		—			—			—			10,415			10,415			10,415
Other Comprehensive Income, net of tax:
Unrealized losses on securities available for sale during the period, net of tax of $(1,085)		—			—			—			—			(1,960	)		—
Add: reclassification adjustment, net of tax of $(152)		—			—			—			—			(283	)		—

Other comprehensive loss		—			—			(2,243	)		—			(2,243	)		(2,243	)

Comprehensive income		—			—			—			—		$	8,172			—

Cash dividends ($.56 per share)		—			—			—			(4,009	)					(4,009	)
Stock options exercised		7			14			—			—						21
Repurchase of common stock		(143	)		(675	)		—			—						(818	)

Balance, September 30, 2003	$	35,748		$	7,482		$	3,967		$	70,540					$	117,737

Balance, January 1, 2004	$	35,764		$	7,578		$	4,233		$	72,255					$	119,830
Net income		—			—			—			11,131			11,131			11,131
Other Comprehensive Income, net of tax:
Unrealized losses on securities available for sale during the period, net of tax of $(716)		—			—			—			—			(1,330	)

Other comprehensive loss		—			—			(1,330	)		—			(1,330	)		(1,330	)

Comprehensive income		—			—			—			—		$	9,801			—

Cash dividends ($.58 per share)		—			—			—			(4,154	)					(4,154	)
Restricted stock awards		24			139			—			—						163
Stock option exercise		14			25			—			—						39

Balance, September 30, 2004	$	35,802		$	7,742		$	2,903		$	79,232					$	125,679

See accompanying notes to consolidated financial statements.

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(000 OMITTED)


	NINE MONTHS ENDED SEPTEMBER 30,
	2004			2003
	(unaudited)			(unaudited)
OPERATING ACTIVITIES
Net income	$	11,131		$	10,415
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,953			968
Deferred tax benefit		(729	)		(1,133	)
Depreciation and amortization		2,783			2,194
(Gain) on sale of securities available for sale		—			(435	)
(Gain) on sale of other real estate		—			(20	)
(Gain) on sale of fixed assets		(5	)		(24	)
Amortization of premiums and discounts on securities		609			503
Fees on mortgage loans sold		(2,015	)		(3,610	)
Proceeds from sale of mortgage loans		121,809			213,644
Origination of loans for sale		(120,544	)		(200,342	)
Changes in assets and liabilities:
Decrease (increase) in interest receivable		245			(386	)
(Increase) in intangible assets		—			(18,920	)
(Increase) in other assets		(647	)		(1,426	)
Increase (decrease) in interest payable		(87	)		481
Increase in other liabilities		567			1,513

Net cash provided by operating activities		15,070			3,422

INVESTING ACTIVITIES
Proceeds from sale of securities available for sale		38			74,378
Proceeds from maturities and principal payments of securities available for sale		87,342			160,192
Purchase of securities available for sale		(23,679	)		(325,009	)
Purchase of premises and equipment		(1,743	)		(7,324	)
Proceeds from sale of premises and equipment		48			58
Additions to other real estate		—			(527	)
Proceeds from sale of other real estate		131			168
Increase in cash surrender value of life insurance		—			(128	)
Net increase in loans		(111,214	)		(164,280	)

Net cash used in investing activities		(49,077	)		(262,472	)

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(000 OMITTED)


	NINE MONTHS ENDED SEPTEMBER 30,
	2004			2003
	(unaudited)			(unaudited)
FINANCING ACTIVITIES
Net increase in demand, money market and savings deposits		25,290			157,468
Net increase in time deposits		14,657			90,053
Proceeds (repayment) of Federal Home Loan Bank advances		4,940			(3,060	)
Net increase in repurchase agreements		2,005			15,190
Net (decrease) in federal funds purchased		(15,000	)		—
Net increase (decrease) in short-term borrowings		(6,286	)		4,313
Issuance of trust preferred capital notes		20,000			—
Repurchase of common stock		—			(818	)
Proceeds from exercise of stock options		39			21
Cash dividends paid on common stock		(4,154	)		(4,009	)

Net cash provided by financing activities		41,491			259,158

Increase in cash and cash equivalents		7,484			108

CASH AND CASH EQUIVALENTS
Beginning of the period		45,178			71,547

End of the period	$	52,662		$	71,655

Supplemental Schedule of Noncash Investing Activities
Unrealized gain (losses) on securities available for sale	$	2,046		$	(3,450	)

Other real estate acquired in settlement of loans	$	—		$	157

Restricted common stock issued	$	163		$	—

See accompanying notes to consolidated financial statements.

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

Virginia Financial Group, Inc. (the “Company”) is a Virginia multi-bank holding company headquartered in Culpeper, Virginia. The Company owns Second Bank & Trust and its subsidiary, Second Service Company; Virginia Heartland Bank and its subsidiary, Virginia Heartland Service Corporation; Planters Bank & Trust Company of Virginia and its subsidiary, Planters Insurance Agency, Inc.; Virginia Commonwealth Trust Company, and VFG Limited Liability Trust. The consolidated statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts have been eliminated. In the opinion of management, the accompanying consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of September 30, 2004 and December 31, 2003, the results of operations for the three months and nine months ended September 30, 2004 and 2003, and cash flows for the nine months ended September 30, 2004 and 2003. The statements should be read in conjunction with the Notes to Financial Statements included in the Company’s Annual Report for the year ended December 31, 2003.

2.	The results of operations for the three month and nine month periods ended September 30, 2004 and 2003 are not necessarily indicative of the results to be expected for the full year. Certain reclassifications have been made to prior period balances to conform to the current presentation.

3.	The Company’s securities portfolio is composed of the following (000 omitted):


	Amortized Cost		Fair Value
Securities Held to Maturity:
	September 30, 2004
	(unaudited)
Obligations of States and Political Subdivisions	$	5,846	$	6,253


	December 31, 2003
Obligations of States and Political Subdivisions	$	5,837	$	6,465


Securities Available for Sale:

	September 30, 2004
	(unaudited)
U.S. Treasury securities	$	7,025	$	7,287
U.S. Government securities		112,865		112,886
State and municipals		71,035		74,637
Corporate bonds		9,061		9,435
Collateralized mortgage obligations		4,718		4,773
Mortgage-backed securities		73,296		73,300
Equity securities		2,722		2,869
Restricted stock		6,182		6,182
Other securities		727		727

	$	287,631	$	292,096

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003


	December 31, 2003
U.S. Treasury securities	$	33,048	$	33,552
U.S. Government securities		127,418		128,571
State and municipals		79,818		83,747
Corporate bonds		10,004		10,605
Collateralized mortgage obligations		6,453		6,585
Mortgage-backed securities		88,876		88,849
Equity securities		1,575		1,794
Restricted stock		4,257		4,257
Other securities		501		501

	$	351,950	$	358,461

The following table is a presentation of the aggregate amount of unrealized loss in investment securities at September 30, 2004. The aggregate is determined by summation of all the related securities that have a continuous loss at September 30, and the length of time that the loss has been unrealized is shown by terms of “less than 12 months” and “12 months or more”. The fair value shown is the estimated market value at September 30, 2004 (000 omitted):


	Less than 12 months				12 months or more				Fair Value		Total Unrealized Loss
Description of Securities	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Total Unrealized Loss
U.S. Treasury securities and U.S. Government securities	$	43,431	$	650	$	—	$	—	$	43,431	$	650
Mortgage backed securities		41,633		449		—		—		41,633		449
State and municipals		5,507		48		—		—		5,507		48
Collateralized mortgage obligations		—		—		—		—		—		—

Subtotal debt securities		90,571		1,147		—		—		90,571		1,147

Common stock		—		—		70		233		70		233
Preferred stock		—		—		524		68		524		68

Total temporarily impaired securities	$	90,571	$	1,147	$	594	$	301	$	91,165	$	1,448

There are a total of fifty-four securities that have unrealized losses as of September 30, 2004, seventeen U.S. Treasuries or agency securities, eighteen U.S. Agency MBS securities, fourteen municipal securities, four common stock securities, and one preferred stock security.

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

The debt securities are obligations of entities that are excellent credit risks. The impairment as noted is the result of market conditions and does not reflect on the ability of the issuers to repay the debt obligations. All debt securities have continuous losses at quarter end less than 12 months.

The common stock category includes four issuers that have shown a loss for more than one year. All the stocks are within the technology sector and prices of the stocks have had a strong correlation with the significant drop in the overall valuation level of this industry over the last several years. None of the issuers have entered into bankruptcy proceedings and the market for each of the stocks is active and liquid. The impairment does not represent a significant financial impact to the Company, and therefore the positions can be maintained indefinitely.

The preferred stock category has one issue that is showing a loss of more than 12 months. The issuer is the Federal Home Loan Mortgage Corporation (Freddie Mac). The impairment is the result of interest rate market conditions. The fixed income nature of this investment causes significant movement in value in relation to the fixed income market. However, there is no change in the dividend stream as a result.

4.	The Company’s loan portfolio is composed of the following (000 omitted):


	September 30, 2004			December 31, 2003
	(unaudited)
Real estate loans:
Construction	$	106,356		$	94,372
Secured by 1 – 4 family residential		316,425			283,631
Commercial and multifamily		479,760			414,476
Commercial, financial and agricultural loans		82,307			73,852
Consumer loans		45,587			48,154
All other loans		2,740			8,585

		1,033,175			923,070

Deferred loan costs (fees)		333			(381	)
Allowance for loan losses		(11,300	)		(9,743	)

	$	1,022,208		$	912,946

5.	Activity in the allowance for loan losses is as follows (000 omitted):


	September 30, 2004			December 31, 2003			September 30, 2003
	(unaudited)						(unaudited)
Balance at January 1	$	9,743		$	9,180		$	9,180

Recoveries added to the allowance		142			229			189
Loan losses charged to the allowance		(538	)		(956	)		(679	)
Provision recorded to expense		1,953			1,290			968

Balance at end of period	$	11,300		$	9,743		$	9,658

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

Information about impaired loans as of the periods indicated is as follows (000’s omitted):


	September 30, 2004		December 31, 2003
	(unaudited)
Impaired loans for which an allowance has been provided	$	5,545	$	3,128
Impaired loans for which an allowance has not been provided		3,773		3,474

Total impaired loans		9,318		6,602

Allowance provided for impaired loans, included in the allowance for loan losses	$	1,278	$	1,281

6.	Short-term Borrowings:

Outstanding short-term borrowings consisted of (000’s omitted):


	September 30, 2004		December 31, 2003
	(unaudited)
Federal Home Loan Bank Advances	$	—	$	—
Line of credit – Correspondent bank		—		6,500
Federal Reserve borrowings		240		26

	$	240	$	6,526

The Company utilizes overnight advances from the Federal Home Loan Bank of Atlanta for short term funding needs. The banking subsidiaries have available a combined $187.9 million line of credit with the Federal Home Loan Bank of Atlanta. Advances on the line are secured by a blanket lien on the 1 to 4 family dwelling loan portfolios of the affiliate banks, which totaled $322.4 million at September 30, 2004.

The Company has a line of credit agreement with a correspondent bank for general working capital needs. The $15 million line is unsecured, calls for variable interest payments and is payable on demand.

Second Bank & Trust has an agreement with the Federal Reserve where it can borrow funds deposited by its customers. This agreement calls for variable interest and is payable on demand. U. S. Government securities and U. S. Treasury notes are pledged as collateral. The maximum amount available under this agreement is $1,000,000.

Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one to four days from the transaction date. Securities sold under agreement to repurchase are reflected at the amount of cash received in connection with the transaction.

The average balance of short-term borrowings outstanding did not exceed 30 percent of stockholders’ equity for the nine months ended September 30, 2004 or the year ended December 31, 2003.

7.	Long-term Debt:

The Company has outstanding fixed-rate, long-term debt with the Federal Home Loan Bank of Atlanta of $14.1 million at September 30, 2004 that matures through 2010. At September 30, 2004, the interest rates on

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

the fixed-rate, long-term advances ranged from 1.96% to 7.07%. One advance totaling $80 thousand at September 30, 2004 requires quarterly principal payments totaling $20 thousand plus interest. The remainder of the advances requires quarterly interest payments with principal due upon maturity. The average interest rate was 5.12% at September 30, 2004 with an average balance outstanding of $9.6 million.

The Company also has outstanding $20 million of floating rate trust preferred securities. Under the terms of the Trust Preferred transaction, the securities will mature in 30 years and are redeemable, in whole or in part, without penalty, at the option of the Company after five years. The securities have a floating rate, which will be reset quarterly, with a current rate of 4.75%.

The contractual maturities of long-term debt are as follows:


2004	$	20
2005		4,060
2006		5,000
2010		5,000
2034		20,000

	$	34,080

8.	Earnings Per Share:

The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock for the three month periods ended September 30, 2004 and 2003.


	2004			2003
	Shares	Per Share Amount		Shares	Per Share Amount
Basic earnings per share	7,160,417	$	.56	7,149,926	$	.49

Effect of dilutive securities:
Stock options	41,224			36,805

Diluted earnings per share	7,204,399	$	.55	7,186,731	$	.49

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

The following shows the weighted average number of shares used in computing earnings per share and the effect on weighted average number of shares of diluted potential common stock for the nine month periods ended September 30, 2004 and 2003.


	2004			2003
	Shares	Per Share Amount		Shares	Per Share Amount
Basic earnings per share	7,157,833	$	1.56	7,157,482	$	1.46

Effect of dilutive securities:
Stock options	43,982			35,326

Diluted earnings per share	7,201,815	$	1.55	7,192,808	$	1.45

In 2004 and 2003, stock options representing 17,383 and 11,100 shares, respectively, were not included in the calculation of earnings per share as their effect would have been anti-dilutive.

9.	Stock Compensation Plan:

At September 30, 2004, the Company has a stock-based employee compensation plan which is accounted for under the recognition and measurement principles of APB Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share for the nine months ended September 30, 2004 and 2003 if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation (000’s omitted).


	2004			2003
Net income, as reported	$	11,131		$	10,415
Deduct: total stock-based employee compensation expense determined based on fair value method for all awards		(53	)		(32	)

Pro forma net income	$	11,078		$	10,383

Earnings per share:
Basic – as reported	$	1.56		$	1.46

Basic – pro forma	$	1.55		$	1.45

Diluted – as reported	$	1.55		$	1.45

Diluted – pro forma	$	1.54		$	1.44

VIRGINIA FINANCIAL GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

10.	Employee Benefit Plan

The Company has a noncontributory pension plan which conforms to the Employee Retirement Income Security Act of 1974 (ERISA). The amount of benefits payable under the plan is determined by an employee’s period of credited service. The amount of normal retirement benefit will be determined based on a Pension Equity Credit formula. The employee receives credits based on their age and years of service. The plan provides for early retirement for participants with five years of service and the attainment of age 55. The benefits are payable in single or joint/survivor annuities as well as a lump sum payment upon retirement or separation of service.

The components of net periodic benefit cost are as follows:


	Nine Months Ended Sept. 30,
	2004			2003
Service cost	$	147		$	171
Interest cost		203			201
Expected return on plan assets		(228	)		(189	)
Amortization of prior service cost		24			24
Amortization of net (gain) loss		13			(3	)

Net periodic benefit cost	$	159		$	204

The Company made an annual cash contribution of $129 thousand to the plan during the second quarter of 2004, and no further contributions are anticipated for this year.

VIRGINIA FINANCIAL GROUP, INC.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following discussion provides information about the major components of the results of operations, financial condition, liquidity and capital resources of Virginia Financial Group, Inc. (the Company). This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and supplemental financial data.

In addition to historical information, statements contained in this report that are not historical facts may be construed as forward-looking statements. The forward-looking statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from historical results, or those anticipated. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date thereof.

OVERVIEW

Virginia Financial Group, Inc. (VFG) is a bank holding company incorporated under the laws of the Commonwealth of Virginia. Currently, VFG is one of the largest independent bank holding companies headquartered in the Commonwealth of Virginia. VFG’s trust affiliate, Virginia Commonwealth Trust Company, is currently on of the largest independent trust companies headquartered in the Commonwealth of Virginia. Affiliates of VFG include: Planters Bank & Trust Company of Virginia - in Staunton, Second Bank & Trust - in Culpeper, Virginia Heartland Bank - in Fredericksburg and Virginia Commonwealth Trust Company - in Culpeper. The organization has a network of thirty-seven branches serving a contiguous market throughout central, south central and southwest Virginia. Virginia Commonwealth Trust Company has offices in Culpeper, Charlottesville, Fredericksburg, Harrisonburg and Staunton.

VFG’s affiliate banks are community-oriented and offer services customarily provided by full-service banks, including individual and commercial demand and time deposit accounts, commercial and consumer loans, residential mortgages, credit card services and deposit services. VFG’s affiliate banks offer internet banking access for banking services, and online bill payment for both consumers and commercial customers. Lending is focused on individuals and small and middle-market businesses in the local market of VFG’s affiliate banks. VFG’s trust company provides a variety of wealth management and personal trust services including estate administration, employee benefit plan administration and planning specifically addressing the investment and financial management needs of its customers. Each affiliate is run autonomously, with the holding company providing common services such as corporate finance, marketing, human resources, compliance, audit and loan review.

Critical Accounting Policies

General

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The Company’s affiliate Banks conduct an analysis of the loan portfolio on a regular basis. This analysis is used in assessing the sufficiency of the allowance for loan losses and in the determination of the necessary provision for loan losses. The review process generally begins with lenders identifying problem loans to be reviewed on an individual basis for impairment. When a loan has been identified as impaired, a specific reserve may be established based on management’s calculation of the loss embedded in the individual loan. In addition to impairment testing, the Banks have a eight point grading system for each non-homogeneous loan in the portfolio. Loans meeting the criteria for impairment are segregated for analysis from performing loans within the portfolio. Loans are then grouped by loan type and, in the case of commercial loans, by risk rating. Each loan type is assigned an allowance factor based on historical loss experience, economic conditions, and overall portfolio quality including delinquency rates. The total of specific reserves required for impaired classified loans and the calculated reserves by loan category are then compared to the recorded allowance for loan losses. This is the methodology used to determine the sufficiency of the allowance for loan losses and the amount of the provision for loan losses. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Goodwill

The Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), effective January 1, 2002. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, under SFAS 142, acquired intangible assets (such as core deposit intangibles) are separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over their useful life. Branch acquisition transactions were outside the scope of SFAS 142 and, accordingly, intangible assets related to such transactions continued to amortize upon the adoption of SFAS 142. The cost of purchased deposit relationships and other intangible assets, based on independent valuation, are

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

being amortized over their estimated lives not to exceed fifteen years. Amortization expense charged to operations was $173 thousand and $39 thousand for the three months ended September 30, 2004 and 2003, and $520 thousand and $118 thousand for the nine months ended September 30, 2004 and 2003, respectively.

Results of Operations

Virginia Financial Group, Inc.’s consolidated net income for the quarter ended September 30, 2004 amounted to $4.0 million or $.55 per diluted share, compared to earnings of $3.5 million or $.49 per diluted share for the quarter ended September 30, 2003. Net income increased 13.0% and diluted earnings per share increased 12.2% compared to third quarter 2003 results. The Company’s earnings for the third quarter produced an annualized return on average assets (ROA) of 1.11% and return on average equity (ROE) of 12.99%, compared to prior year ratios of 1.20% and 12.09%, respectively.

For the first nine months of 2004, net income was $11.1 million, up 6.9% from $10.4 million for the same period in 2003. Net income per diluted share was $1.55, up 6.9% from $1.45 for the first nine months of 2003. ROA and ROE for the nine month period were 1.05% and 12.24%, compared to 1.22% and 11.97% for the same period in 2003, respectively.

Net Interest Income

Net interest income increased $2.4 million or 22.2% to $13.2 million for the three months ended September 30, 2004. This improvement can be attributed to an expanding net interest margin, and continuing growth in average earning assets. The net interest margin for the three months ended September 30, 2004 was 4.14%, compared to 4.05% for the quarter ended June 30, 2004 and 4.12% for the quarter ended September 30, 2003. The increase is largely due to the increase in short term rates and the resulting impact on loan yields which are indexed to the prime rate. The net interest margin for the nine month period ended September 30, 2004 was 4.10%, compared to 4.21% for the same period in 2003.

The following tables provide information on average earning assets and interest-bearing liabilities for the three months and nine months ended September 30, 2004 and 2003 as well as amounts and rates of tax equivalent interest earned and interest paid. The tax equivalent adjustment, utilizing a federal statutory rate of 35%, amounted to $436 thousand and $549 thousand for the three months ended September 30, and $1.3 million and $1.7 million for the nine months ended September 30, 2004 and 2003, respectively.

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS


	Quarter Ended September 30,
	2004						2003
*Dollars in thousands*	Average Balance		Interest Inc/Exp		Average Rates		Average Balance		Interest Inc/Exp		Average Rates
Assets
Loans receivable, net	$	1,009,098,814	$	15,027,427	5.92	%	$	755,222,127	$	12,233,073	6.43	%
Investment securities
Taxable		226,490,641		2,249,404	3.95	%		239,450,228		2,273,723	3.80	%
Tax exempt		65,267,961		1,071,656	6.53	%		77,260,040		1,354,470	7.01	%

Total Investments		291,758,602		3,321,060	4.53	%		316,710,268		3,628,193	4.58	%

FHLB int bearing		323,067		1,289	1.59	%		313,263		25,768	32.63	%
Federal funds sold		5,962,083		22,108	1.48	%		16,946,229		51,037	1.19	%

		298,043,752		3,344,457	4.46	%		333,969,760		3,704,998	4.44	%

Total Earning Assets		1,307,142,566		18,371,884	5.59	%		1,089,191,887		15,938,071	5.82	%

Non-Earning Assets		118,197,929						92,465,731

Total Assets		1,425,340,495						1,181,657,618

Liabilities and Stockholders' Equity
Time and savings deposits
Interest-bearing transaction accounts	$	196,014,562	$	184,026	0.37	%	$	134,876,643	$	216,835	0.64	%
Money market deposit accounts		181,754,438		413,743	0.91	%		163,709,661		421,622	1.02	%
Passbook savings accounts		144,072,154		233,693	0.65	%		114,981,891		235,237	0.81	%
Certificates of deposit >$100k		122,270,427		1,020,227	3.32	%		93,176,952		880,914	3.75	%
Certificates of deposit <$100k		369,100,912		2,469,840	2.66	%		315,843,023		2,641,615	3.32	%

Total Time and Savings Deposits		1,013,212,493		4,321,529	1.70	%		822,588,170		4,396,223	2.12	%

Federal funds purchased		21,754,651		46,208	0.85	%		40,377,100		88,252	0.87	%
Trust Preferred Securities		19,999,999		220,609	4.39	%		—		—
Other short term borrowings		1,293,478		5,132	1.58	%		403,325		1,485	1.46	%
Federal Home Loan Bank advances		13,504,525		181,461	5.35	%		9,177,826		162,608	7.03	%

		56,552,653		453,410	3.19	%		49,958,251		252,345	2.00	%

Total Interest- Bearing Liabilities		1,069,765,146		4,774,939	1.78	%		872,546,421		4,648,568	2.11	%

Non-Interest- Bearing Liabilities		233,345,465						191,875,534

Total Stockholders' Equity		122,229,884						117,235,663

Total Liabilities and Stockholders' Equity		1,425,340,495						1,181,657,618

Net interest income (tax equivalent)			$	13,596,945					$	11,289,503

Average interest rate spread					3.82	%					3.70	%
Interest expense as percentage of average earning assets					1.45	%					1.69	%
Net interest margin					4.14	%					4.12	%

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS


	Nine months Ending September 30,
	2004						2003
*Dollars in thousands*	Average Balance		Interest Inc/Exp		Average Rates		Average Balance		Interest Inc/Exp		Average Rates
Assets
Loans receivable, net	$	976,363,428	$	43,438,782	5.94	%	$	732,297,011	$	36,621,327	6.69	%
Investment securities
Taxable		242,745,631		7,114,635	3.91	%		222,299,115		6,555,320	3.93	%
Tax exempt		67,586,427		3,328,619	6.58	%		78,492,230		4,188,248	7.11	%

Total Investments		310,332,058		10,443,254	4.50	%		300,791,345		10,743,568	4.76	%

FHLB int bearing		458,136		3,334	0.97	%		436,258		28,032	8.59	%
Federal funds sold		3,356,694		31,571	1.26	%		18,407,982		168,928	1.23	%

		314,146,888		10,478,159	4.46	%		319,635,585		10,940,528	4.56	%

Total Earning Assets		1,290,510,316		53,916,941	5.58	%		1,051,932,596		47,561,855	6.04	%

Non-Earning Assets		121,417,205						89,880,649

Total Assets		1,411,927,521						1,141,813,245

Liabilities and Stockholders' Equity
Time and savings deposits
Interest-bearing transaction accounts	$	193,990,441	$	753,997	0.52	%	$	128,686,454	$	689,997	0.72	%
Money market deposit accounts		173,922,313		1,194,696	0.92	%		160,028,427		1,422,557	1.19	%
Passbook savings accounts		140,716,072		717,736	0.68	%		111,117,410		820,018	0.99	%
Certificates of deposit >$100k		119,364,249		3,000,241	3.36	%		91,454,193		2,640,905	3.86	%
Certificates of deposit <$100k		370,699,992		7,426,262	2.68	%		313,436,061		8,107,623	3.46	%

Total Time and Savings Deposits		998,693,067		13,092,932	1.75	%		804,722,545		13,681,100	2.27	%

Federal funds purchased		25,919,258		161,052	0.83	%		22,206,170		159,193	0.96	%
Trust Preferred Securities		14,379,562		442,475	4.11	%		—		—
Other short term borrowings		12,798,175		140,670	1.47	%		485,475		4,251	1.17	%
Federal Home Loan Bank advances		12,584,818		519,013	5.51	%		10,758,022		532,950	6.62	%

		65,681,813		1,263,210	2.57	%		33,449,667		696,394	2.78	%

Total Interest- Bearing Liabilities		1,064,374,880		14,356,142	1.80	%		838,172,212		14,377,494	2.29	%

Non-Interest-Bearing Liabilities		226,080,678						187,256,629

Total Stockholders' Equity		121,471,963						116,384,404

Total Liabilities and Stockholders' Equity		1,411,927,521						1,141,813,245

Net interest income (tax equivalent)			$	39,560,799					$	33,184,361

Average interest rate spread					3.78	%					3.75	%
Interest expense as percentage of average earning assets					1.49	%					1.83	%
Net interest margin					4.10	%					4.21	%

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

Noninterest Income

Total noninterest income was $3.6 million for the third quarter of 2004, a decrease of 12.8% compared to $4.2 million for the same period in 2003. Excluding securities gains of $365 thousand in 2003, the decrease in 2004 as compared to 2003 amounted to $169 thousand or 4.4%. VFG continued to see a decrease in mortgage refinance activity, with total mortgage revenue decreasing $754 thousand or 58.5% to $534 thousand for the third quarter of 2004. VFG’s mortgage operation originations for the quarter constituted 66.3% purchase loan activity. Fees from retail banking operations amounted to $2.0 million for the third quarter of 2004, an increase of $566 thousand or 39.2%. Such increase can be attributed to deposit growth and fee initiatives such as overdraft protection privilege and new product alignment. Fees from trust and investment services for the third quarter of 2004 amounted to $845 thousand, an increase of $69 thousand or 8.9% compared to the same quarter in 2003.

Total noninterest income was $11.0 million for the nine months ended September 30, 2004, down $657 thousand or 5.6% from the same period in 2003. The decline in revenue from mortgage operations and increase in increase in retail banking fees were similar trends for the nine month period.

Noninterest Expense

Noninterest expense for the third quarter of 2004 amounted to $10.4 million, an increase of $526 thousand or 5.3% for the same quarter in 2003. Excluding nonrecurring expenses in 2003 of $340 thousand associated with integration of the First Virginia branches, noninterest expenses increased $866 thousand or 9.1%. Components of this increase are higher operating costs associated with the loan production office in Lynchburg, amortization of intangibles, tele-communication costs and professional fees. These expenses were offset somewhat by decreases in costs associated with mortgage related commissions, medical benefits, and other incentive related accruals. VFG’s efficiency ratio was 60.25% for the third quarter of 2004, compared to 63.22% for the same quarter in 2003.

Noninterest expense for the nine month period of 2004 amounted to $31.5 million, up $3.3 million or 11.5% from the same period in 2003. The increases are largely attributable to the Company’s expansion efforts, and the incremental operating costs and intangible amortization associated with the eight purchased branches, loan production offices in Charlottesville and Lynchburg and a de novo branch in Fishersville, Virginia. Also contributing to the period increase were professional fees associated with governance initiatives, consulting for an operations review and Sarbanes Oxley compliance, and placement fees for executive recruitment.

Income Taxes

Income tax expense for the three months ended September 30, 2004 amounted to $1.7 million resulting in an effective tax rate of 30.4% compared to $1.2 million, or 25.1%, for the three months ended September 30, 2003. For the nine months ended September 30, 2004 income tax expense was $4.7 million resulting in an effective rate of 29.6%, compared to $3.6 million or 25.5% for the same period in 2003. The increase in the effective tax rate for the quarter and nine month period is a result of a decrease in earnings from tax-exempt assets as a percentage of total income, and an increase in the Company’s statutory rate. The rate of loan growth has resulted in a decrease in the securities component of the Company’s balance sheet, resulting in less municipal security holdings and related tax exempt interest.

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

Asset Quality

The Company’s provision for loan losses for the third quarter was $636 thousand, up $313 thousand or almost 100% from the same period in 2003. For the nine month period, the provision for loan losses was $2.0 million, up $985 thousand or over 100% from the same period in 2003. The increases are directly attributed to the aforementioned higher rates of loan growth for each period, particularly commercial real estate growth in our new markets of Charlottesville and Lynchburg. Nonperforming assets and net charge-offs were at improved levels, with non-performing assets as a percentage of total assets of .28% at September 30, 2004, compared to .55% at September 30, 2003. Net charge-offs for the third quarter were $135 thousand, compared to net charge-offs of $9 thousand for the same period in 2003. Net charge-offs as a percentage of average loans were .01% for the third quarter and .04% for the nine month period, compared to .01% and .06% for the same periods in 2003. At September 30, 2004, the allowance for loan losses as a percentage of non-performing assets was 278.4%, while the allowance as a percentage of total loans amounted to 1.09%, up slightly from 1.06% at December 31, 2003.

The following table provides information on asset quality statistics for the periods presented (000 omitted):


	Sept. 30, 2004			December 31, 2003			Sept. 30, 2003
Non accrual loans	$	2,116		$	2,677		$	1,824
Troubled debt restructurings		1,937			4,525			4,572
Other real estate owned		5			454			1,233
Loans past due as to principal or interest for 90 days or more accruing interest		1			25			11

Total nonperforming assets	$	4,059		$	7,681		$	7,083

Nonperforming assets to total assets		.28	%		.55	%		.55	%

Nonperforming assets to loans and other property		.39	%		.83	%		.88	%

Allowance for loan losses as a percentage of loans receivable		1.09	%		1.06	%		1.12	%

Allowance for loan losses as a percentage of nonperforming assets		278.39	%		126.85	%		126.60	%

Net charge-offs as a percentage of average loans receivable		.04	%		.09	%		.06	%

Liquidity and Capital Resources

Capital Resources

The management of capital in a regulated financial services industry must properly balance return on equity to stockholders while maintaining sufficient capital levels and related risk-based capital ratios to satisfy regulatory requirements. Additionally, capital management must also consider acquisition opportunities that may exist, and the resulting accounting treatment. The Company’s capital management strategies have been developed to provide attractive rates of returns to stockholders, while maintaining its “well-capitalized” position at each of the banking subsidiaries.

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

The primary source of additional capital to the Company is earnings retention, which represents net income less dividends declared. During the nine months ended September 30, 2004, the Company retained $7.0 million, or 62.7% of its net income. Stockholders’ equity increased by $5.8 million, reflecting the earnings retention and a decrease of $1.3 million in accumulated comprehensive income net of tax, which relates primarily to a universal decline in bond market valuations, resulting in a decrease in unrealized gains on securities available-for-sale during the period.

The Company and its banking subsidiaries are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and the subsidiary banks’ financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and its banking subsidiaries must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and reclassifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and its banking subsidiaries to maintain minimum amounts and ratios of total and Tier 1 capital to average assets. Management believes, as of September 30, 2004 that the Company and the subsidiary banks met all minimum capital adequacy requirements to which they are subject and are categorized as “well capitalized.” There are no conditions or events that management believes have changed the subsidiary banks’ well capitalized position.

The following table includes information with respect to the Company’s risk-based capital as of September 30, 2004 (000 omitted):


Tier 1 capital	$	123,113
Tier 2 capital		11,366
Total risk-based capital		134,479
Total risk-weighted assets		1,083,706
Average adjusted total assets		1,403,868
Capital ratios:
Tier 1 risk-based capital ratio		11.36	%
Total risk-based capital ratio		12.41	%
Leverage ratio (Tier 1 capital to average adjusted total assets)		8.77	%
Equity to assets ratio		8.73	%
Tangible equity to assets ratio		7.36	%

Liquidity

Liquidity is identified as the ability to generate or acquire sufficient amounts of cash when needed and at a reasonable cost to accommodate withdrawals, payments of debt, and increased loan demand. These events may

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

occur daily or other short-term intervals in the normal operation of the business. Experience helps management predict time cycles in the amount of cash required. In assessing liquidity, management gives consideration to relevant factors including stability of deposits, quality of assets, economy of market served, concentrations of business and industry, competition, and the Company’s overall financial condition. The Company’s primary source of liquidity is cash, securities in our available for sale portfolio and a $15 million line of credit with a correspondent bank. In addition, the Banks have substantial lines of credit from their correspondent banks and access to the Federal Reserve discount window and Federal Home Loan Bank of Atlanta to support liquidity as conditions dictate.

The liquidity of the parent company also represents an important aspect of liquidity management. The parent company’s cash outflows consist of overhead associated with corporate expenses, executive management, finance, marketing, human resources, audit and compliance and loan review functions. It also includes outflows associated with dividends to shareholders. The main sources of funding for the parent company are the management fees and dividends it receives from its banking and trust subsidiaries, a working line of credit with a correspondent bank, and availability of the trust preferred security market as deemed necessary. The Company’s capital base provides the resource and ability to support the assets of the Company and provide capital for future expansion.

The Company completed the issuance of $20 million of floating rate trust preferred securities during the first quarter of 2004 in a privately negotiated transaction. The proceeds from the sale of the securities will be used for general corporate purposes which may include capital management for its affiliates, acquisitions, retirement of indebtedness, repurchase of the Company’s common stock and other investments.

In the judgment of management, the Company maintains the ability to generate sufficient amounts of cash to cover normal requirements and any additional funds as needs may arise.

Effects of Inflation

The effect of changing prices on financial institutions is typically different from other industries as the Company’s assets and liabilities are monetary in nature. Interest rates and thus the Company’s asset liability management is impacted by changes in inflation, but there is not a direct correlation between the two measures. Management monitors the impact of inflation on the financial markets.

Recent Accounting Pronouncements

On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments” (“SAB 105”). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments (“IRLC”), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, “Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133.” Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The Company has adopted the provisions of SAB 105. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, management does not anticipate that this guidance will have a material adverse effect on either the Company’s consolidated financial position or consolidated results of operations.

Effective March 31, 2004, Emerging Issues Task Force Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”) was issued. EITF 03-1 provides

VIRGINIA FINANCIAL GROUP, INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF

OPERATIONS

guidance for determining the meaning of “other-than-temporarily impaired” and its application to certain debt and equity securities within the scope of Statement of Financial Accounting Standards No. 115 “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”) and investments accounted for under the cost method. The guidance requires that investments which have declined in value due to credit concerns or solely due to changes in interest rates must be recorded as other-than-temporarily impaired unless the Company can assert and demonstrate its intention to hold the security for a period of time sufficient to allow for a recovery of fair value up to or beyond the cost of the investment which might mean maturity. This issue also requires disclosures assessing the ability and intent to hold investments in instances in which an investor determines that an investment with a fair value less than cost is not other-than-temporarily impaired.

On September 30, 2004, the Financial Accounting Standards Board decided to delay the effective date for the measurement and recognition guidance contained in Issue 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. The disclosure guidance in Issue 03-1 was not delayed.

Access to Filings

The Company provides access to their SEC filings through the corporate Web site at www.vfgi.net. After accessing the Web site, the filings are available upon selecting the SEC Filings & Other Documents icon. Reports available include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after the reports are electronically filed with or furnished to the SEC.

VIRGINIA FINANCIAL GROUP, INC.

PART I – FINANCIAL INFORMATION

ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no significant changes to the quantitative and qualitative market risk disclosures in the Company’s Form 10-K for the year ended December 31, 2003.

ITEM 4 – CONTROLS AND PROCEDURES

We are required to include in our periodic reports information regarding our controls and procedures for complying with the disclosure requirements of the federal securities laws. These disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act, is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

We have established disclosure controls and procedures to ensure that material information related to the Company is made known to our principal executive officer and principal financial officer on a regular basis, in particular during the periods in which our quarterly and annual reports are being prepared. Our principal executive officer and principal financial officer evaluated the effectiveness of these disclosure controls and procedures as of the end of the period covered by this report and, based on their evaluation, concluded that our disclosure controls and procedures are operating effectively.

Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that our disclosure controls and procedures will detect or uncover every situation involving the failure of persons within the organization to disclose material information otherwise required to be set forth in our period reports.

Our management is also responsible for establishing and maintaining adequate internal controls over financial reporting and control of our assets to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. There were no changes in our internal control over financial reporting or control of assets during the quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting or control of assets.

PART II - OTHER INFORMATION

ITEM	1. LEGAL PROCEEDINGS.

There are no material legal proceedings to which the Company or any of its subsidiaries, directors, or officers is a party or by which they, or any of them, are threatened. Any legal proceeding presently pending or threatened against Virginia Financial Group, Inc. and its subsidiaries are either not material in respect to the amount in controversy or fully covered by insurance.

ITEM	2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

The Company has a stock repurchase program authorized that is not currently active, with 210,000 shares remaining available for repurchase.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

ITEM 5. OTHER INFORMATION.

Not applicable.

ITEM	6. EXHIBITS:

(a) The following exhibits either are filed as part of this Report or are incorporated herein by reference:



Exhibit No. 2		Agreement and Plan of Reorganization incorporated by reference to Agreement and Plan of Reorganization filed as Exhibit A to Form S-4 Amendment No. 2 filed on November 20, 2001 (File No. 333-69216).

Exhibit No. 3.1		Articles of Incorporation incorporated by reference to Exhibit 3.1 to Form 8-K filed on January 30, 2002.

Exhibit No. 3.2		Bylaws incorporated by reference to Exhibit 3.2 to Form 8-K filed on January 30, 2002.

Exhibit No. 4		Stock Option Agreement is incorporated by reference to Exhibit B to Form S-4 Amendment No. 2 filed on November 20, 2001 (File No. 333-69216).

Exhibit No. 4.1		Stock Incentive Plan is incorporated by reference to Form S-8 filed on February 26, 2002 (File No. 333-83410).

Exhibit No. 10		Employment contracts of certain officers incorporated by reference to Form S-4 Amendment No. 3 filed on December 3, 2001 (File No. 333-69216).

Exhibit No. 31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

Exhibit No. 31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.

Exhibit No. 32		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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

VIRGINIA FINANCIAL GROUP, INC.

/s/ O.R. Barham, Jr.

O.R. Barham, Jr.

President and Chief Executive Officer

November 5, 2004

/s/ Jeffrey W. Farrar

Jeffrey W. Farrar, CPA

Executive Vice President and Chief Financial Officer

November 5, 2004

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