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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2004

For the transition period from                      to                     

Commission file number 000-24302

COLUMBIA BANCORP

(Exact name of registrant as specified in its charter)

7168 Columbia Gateway Drive, Columbia, Maryland 21046

(Address of principal executive offices)

(410) 423-8000

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, par value $0.01 per share

(Title of class)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ¨.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes  x    No  ¨

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State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter.

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

Documents Incorporated by Reference:

Portions of Definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, incorporated by reference into Part III.

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FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K and certain information incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements included or incorporated by reference in this Annual Report on Form 10-K, other than statements that are purely historical, are forward-looking statements. Statements that include the use of terminology such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “estimates” and similar expressions also identify forward-looking statements. The forward-looking statements are based on Columbia Bancorp’s current intent, belief and expectations Forward-looking statements in this Annual Report on Form 10-K include, but are not limited to:

Part I. Item 3. Legal Proceedings:

Part II. Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities:

Part II. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations:

Part II. Item 7A. Quantitative and Qualitative Disclosures About Market Risk:

Part II. Item 8. Note 3. Investments:

These statements are not guarantees of future performance and are subject to certain risks and uncertainties that are difficult to predict. Actual results may differ materially from these forward-looking statements because of interest rate fluctuations, a deterioration of economic conditions in the Baltimore/Washington metropolitan area, a downturn in the real estate market, losses from impaired loans, an increase in nonperforming assets, potential exposure to environmental laws, changes in federal and state bank laws and regulations, the highly competitive nature of the banking industry, a loss of key personnel, changes in accounting standards and other risks described in the Company’s filings with the Securities and Exchange Commission. Existing and prospective investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Report. Columbia Bancorp undertakes no obligation to update or revise the information contained in this Annual Report whether as a result of new information, future events or circumstances or otherwise. Past results of operations may not be indicative of future results. Readers should carefully review the risk factors described under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Investment Considerations – Risk Factors” in this Annual Report and in other documents the Company files from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q to be filed by the Company in 2005.

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PART I

ITEM 1. BUSINESS

General

Columbia Bancorp (the “Company”), a bank holding company, was incorporated in November 1987 under the laws of Maryland and registered under the Bank Holding Company Act of 1956, as amended. The Company organized The Columbia Bank (the “Bank”) as a Maryland trust company and a wholly-owned subsidiary of the Company in May 1988. The Bank currently accounts for substantially all of the Company’s assets. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (“FDIC”). The Bank is headquartered in Columbia, Maryland and as of December 31, 2004 had a total of twenty-four branch locations in Maryland with ten branch locations in Howard County; four branch locations in Baltimore County; two branch locations in Baltimore City; five branch locations in Prince George’s County; and three branch locations in Montgomery County. The Bank also has mortgage and commercial loan origination and investment services offices in Howard, Baltimore, Prince George’s and Montgomery Counties. Wholly-owned subsidiaries of the Bank include McAlpine Enterprises, Inc., Howard I, LLC and Howard II, LLC, which are used primarily to manage properties acquired through foreclosure, and Columbia Leasing, Inc., which is an inactive commercial leasing company. During 2004, the Company formed Columbia Bancorp Statutory Trust I and Columbia Bancorp Statutory Trust II for the purpose of issuing trust preferred securities. These trust subsidiaries are not consolidated with the Company, in accordance with U.S. generally accepted accounting principles. At December 31, 2004, the Company had total assets of $1.2 billion, total loans, net of unearned income, of $950.2 million, total deposits of $912.6 million and stockholders’ equity of $92.3 million.

The Bank is an independent, community bank that seeks to provide personal attention and professional financial services to its customers while offering virtually all of the banking services of larger competitors. Our customers are primarily individuals and small and medium-sized businesses. The Bank’s business philosophy includes offering informed and courteous service, local and timely decision-making, flexible and reasonable operating procedures and consistently applied credit policies.

The executive offices of the Company and the principal office of the Bank are located at 7168 Columbia Gateway Drive, Columbia, Maryland 21046, telephone number (410) 423-8000. The Company files quarterly and annual reports with the Securities and Exchange Commission (“SEC”) on Forms 10-Q and 10-K, respectively, proxy materials on Schedule 14A and current reports on Form 8-K. The Company makes available, free of charge, all of these reports, as well as any amendments, through the Company’s Internet site as soon as is reasonably practicable after they are filed electronically with the SEC. The address of that site is http://www.thecolumbiabank.com. To access the SEC reports, click on “Investor Relations” – “Corporate Profile” – “Documents”. The SEC also maintains an Internet site that contains reports, proxy materials and information statements at http://sec.gov. In addition, the Company will provide paper copies of filings free of charge upon written request. The Company’s website also makes available Corporate Governance material, including such documents as the Code of Conduct and Ethics, Corporate Governance Guidelines and the charters of several of the committees of the Board of Directors. To access this section of our website, click on “Investor Relations” – “Corporate Governance”.

Services of the Bank

The Bank provides comprehensive and service-intensive commercial and retail banking services primarily to individuals and small and medium-sized businesses. The following types of services are offered by the Bank:

Commercial Services:

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Retail Services:

The Bank does not now exercise general trust powers.

Lending Activities

General. The Company’s primary source of income is interest paid on loans. At December 31, 2004, the Company’s loan portfolio, net of unearned income, totaled $950.2 million, representing 80.6% of its total assets of $1.2 billion. The principal categories of loans in the Company’s loan portfolio are real estate development and construction, commercial, residential real estate, commercial real estate and consumer.

Loan Portfolio Composition. The following table sets forth the Company’s loans by major categories as of December 31, 2004.

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Real Estate Development and Construction Loans. Real estate development and construction loans consisted of the following at December 31, 2004:

The Company makes residential real estate development and construction loans generally to provide interim financing on property during the development and construction period. Borrowers include builders, developers and persons who will ultimately occupy the single-family dwelling. The Company disburses residential real estate development and construction loan funds periodically as pre-specified stages of completion are confirmed based upon site inspections. Interest rates on these loans are usually adjustable.

Residential construction loans constitute the largest component of the real estate development and construction loan portfolio, representing primarily loans for the construction of single-family dwellings. At December 31, 2004, loans to individuals for the construction of primary personal residences accounted for $49.0 million of the $139.4 million residential construction loan portfolio. These loans are typically secured by the property under construction, frequently include additional collateral (such as a second mortgage on the borrower’s present home), and commonly have maturities of nine to eighteen months. The remaining $90.4 million of residential construction loans represented loans to residential builders. Approximately 53% of the units under construction were for residential homes for which a binding sales contract existed and the prospective buyers had been pre-qualified for permanent mortgage financing by either third-party lenders (mortgage companies or other financial institutions) or the Company. The Company attempts to obtain the permanent mortgage loan under terms, conditions and documentation standards that permit the sale of the mortgage loan in the secondary mortgage loan market. The Company’s practice is to immediately sell substantially all residential mortgage loans in the secondary market with servicing released. The Company does not retain servicing obligations on such loans.

Loans for the development of residential land represented the second largest component of the real estate development and construction loan portfolio at December 31, 2004, totaling $88.4 million or 25.6% of the portfolio. Generally, development loans are extended when evidence is provided that the lots under development will be or have been sold to builders satisfactory to the Company. These loans are extended for a period of time sufficient to allow for the clearing and grading of the land and the installation of water, sewer and roads, generally for a period of up to 36 months. Residential land development loans generally carry a loan to value ratio not to exceed 75% of the value of the project as completed.

Land acquisition loans comprised a significant portion of the Company’s real estate development and construction loan portfolio, totaling $69.2 million, or 20.0% of the total portfolio at December 31, 2004. The category is comprised of $14.9 million of loans to individuals for the purchase of residential building lots, $21.1 million of loans for the acquisition of property for commercial development and $33.2 million of loans for the acquisition of property by builders for residential development.

The Company also makes commercial construction loans, which totaled $48.3 million, or 14.0% of the real estate development and construction portfolio at December 31, 2004. These loans are generally extended to borrowers who are experienced in the construction field and who possess adequate financial resources in relation to their commitments and obligations. The underwriting process is designed to confirm that the project will be economically feasible and financially viable. It is generally evaluated as though the Company will provide permanent financing.

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The Company has limited its risk in this area of lending by monitoring development and construction loans with on-site inspections and controlling disbursements on loans in process. Development and construction loans are secured by the properties under development or construction and personal guarantees are typically obtained. Further, to assure that reliance is not placed solely upon the value of the underlying collateral, the Company considers the financial condition and reputation of the borrower and any guarantors, the amount of the borrower’s equity in the project, independent appraisals, cost estimates and pre-construction sales information.

Commercial Loans. At December 31, 2004, $226.8 million, or 23.9%, of the Company’s total loan portfolio consisted of commercial business loans. The commercial loan portfolio includes secured and unsecured term loans and lines of credit extended to small and mid-sized local businesses. The Company’s lending policy requires that each loan be evaluated for the adequacy of the repayment sources at the time of approval. The Company closely monitors the financial condition and cash flow of commercial borrowers, in part by reviewing corporate financial statements, personal financial statements and income tax returns. The frequency of submissions of required information depends upon the size and complexity of the credit and the collateral that secures the loan. Collateral is generally required to provide the Company with an additional source of repayment in the event of default by a commercial borrower. The collateral requirements, including the amount and type of the collateral, vary from loan to loan depending on the financial strength of the borrower, but generally may include accounts receivable, inventory, equipment or other assets. It is also the Company’s general policy to obtain personal guarantees from the principals of the commercial loan borrowers.

The following table demonstrates the diversity of the Company’s commercial loan portfolio customer base. The largest industry represented by the Company’s commercial borrowers, comprising 20.3% of the commercial loan portfolio, is the construction industry, which includes land development and subdivision, residential, commercial and industrial construction, and trade contractors. The second largest industry is professional and financial services, which comprises 17.2% of the total portfolio. This diverse group includes a broad range of businesses, including law firms, accounting firms, engineering services, computer programming and armored car services.

Commercial Real Estate Mortgage Loans. The Company also originates mortgage loans secured by commercial real estate. At December 31, 2004, $164.0 million, or 17.3% of the Company’s total loan portfolio, consisted of commercial mortgage loans. Such loans generally involve investment properties secured by office buildings, retail buildings, warehouse and general-purpose business space. Other commercial mortgages consist of owner occupied properties. Although terms and amortization periods vary, the Company’s commercial mortgages generally have maturities or repricing opportunities of five years or less. The following table describes the collateral underlying the commercial real estate mortgage loan portfolio at December 31, 2004:

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The Company seeks to reduce the risks associated with commercial mortgage lending by generally lending in its market area, using conservative loan-to-value ratios (typically 75% to 80%) and obtaining periodic financial statements and tax returns from borrowers to perform annual loan reviews. It is also the Company’s general policy to obtain personal guarantees from the principals of the borrowers and to underwrite the business entity from a cash flow perspective.

Consumer Loans. At December 31, 2004, $196.2 million, or 20.6%, of the Company’s total loan portfolio consisted of consumer loans. The Company offers a variety of consumer loans in order to provide a full range of financial services to its customers; however, outstanding balances are primarily concentrated in home equity and second mortgage loans, which totaled $171.6 million and $18.7 million, respectively, at December 31, 2004.

Home equity loans and lines of credit are originated by the Company for typically up to 90% of the appraised value, less the amount of any existing prior liens on the property. Home equity loans have terms of fifteen to thirty years and the interest rates are generally adjustable. The Company secures these loans with mortgages on the homes (typically a second mortgage). The second mortgage loans originated by the Company have terms ranging from ten to thirty years. They generally carry a fixed rate of interest for the entire term or a fixed rate of interest for the first five years, repricing every five years thereafter at a predetermined spread to the prime rate of interest.

Residential Real Estate Mortgage Loans. The Company originates adjustable and fixed-rate residential mortgage loans in order to provide a full range of products to its customers. The Company generally offers mortgage loans under terms, conditions and documentation that permit their sale in the secondary mortgage market. The Company’s practice is to immediately sell substantially all residential mortgage loans in the secondary market with servicing released. The Company does not retain servicing obligations on such loans. At December 31, 2004, $17.3 million, or 1.8%, of the Company’s total loan portfolio consisted of residential mortgage loans.

For any loans retained by the Company, title insurance insuring the priority of its mortgage lien, as well as general liability, fire and extended coverage casualty insurance protecting the properties securing the loans are required. The Company may require borrowers to advance funds, with each monthly payment of principal and interest, to a loan escrow account from which the Company makes disbursements for items such as real estate taxes, hazard insurance premiums and mortgage insurance premiums. Outside appraisers approved by the Company appraise the properties securing all of the residential mortgage loans originated by the Company.

Other Loans. At December 31, 2004, other loans totaled $668,000, consisting primarily of unscheduled overdrafts of the Company’s retail and commercial customers.

Market

The Company considers its core markets to be the communities within the Baltimore/Washington corridor, particularly the counties of Howard, Baltimore, Montgomery and Prince George’s and Baltimore City. The Company engages in lending activities that take place in a broader geographic footprint, which includes not only the communities of the Baltimore/Washington corridor, but other Maryland counties, the District of Columbia and targeted markets in contiguous states. The following table shows the distribution of the Company’s loans and customer funding throughout its core market and the surrounding area as of December 31, 2004:

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Competition

While promotional activities emphasize the many advantages of dealing with a locally-run institution closely attuned to the needs of its community, the Company faces strong competition in all areas of its operations. This competition comes from entities operating in the Baltimore/Washington metropolitan area, which includes offices of most banks operating in Maryland. Its most direct competition for deposits comes from other commercial banks, savings banks, savings and loan associations and credit unions operating in the Baltimore/Washington marketplace. The Company also competes for deposits with money market mutual funds and with larger banks for cash management customers. The Company competes with banking entities, mortgage banking companies, and other institutional lenders for loans. The competition for loans varies from time to time depending on certain factors. These factors include, among others, the general availability of lendable funds and credit, general and local economic conditions, current interest rate levels, conditions in the mortgage market and other factors that are not readily predictable.

Current federal law allows the acquisition of banks by bank holding companies nationwide. Further, federal and Maryland law permit interstate banking. Recent legislation has broadened the extent to which financial services companies, such as investment banks and insurance companies, may control commercial banks. As a consequence of these developments, competition in the Bank’s principal market may increase, and a further consolidation of financial institutions in Maryland may occur.

Regulation

The Company is registered as a bank holding company under the Bank Holding Company Act of 1956. As such, the Company is subject to regulation and examination by the Federal Reserve Board, and is required to file periodic reports and any additional information that the Federal Reserve Board may require. The Bank Holding Company Act imposes certain restrictions upon the Company regarding the acquisition of stock or assets of any bank of which it is not already the majority owner or, with certain exceptions, of any company engaged in non-banking activities.

The Bank is subject to supervision, regulation and examination by the Bank Commissioner of the State of Maryland and the FDIC. Asset growth, deposits, reserves, investments, loans, consumer law compliance, issuance of securities, payment of dividends, establishment of branches, mergers and consolidations, changes in control, electronic funds transfer, management practices and other aspects of operations are subject to regulation by the appropriate federal and state supervisory authorities. The Bank is also subject to various regulatory requirements of the Federal Reserve Board applicable to FDIC-insured depository institutions.

The Gramm-Leach-Bliley Act of 1999 authorizes a bank holding company that meets specified conditions to become a “financial holding company” and thereby engage in a broader array of financial activities than previously permitted. Such activities can include insurance underwriting and investment banking. The Gramm-Leach-Bliley Act also authorizes banks to engage through “financial” subsidiaries in certain of the activities permitted for financial holding companies. To date, the Company has not elected financial holding company status.

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “PATRIOT Act”) requires financial institutions to develop a customer identification plan that includes procedures to:

Under the provisions of the PATRIOT Act, the Bank is also required from time to time to search its customer data base for the names of known or suspected terrorists as provided by the government.

Due to the extensive regulation of the commercial banking business in the United States, the Company is particularly susceptible to changes in federal and state legislation and regulations.

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Governmental Monetary Policies and Economic Controls

The Company is affected by monetary policies of regulatory agencies, including the Federal Reserve Board, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques available to the Federal Reserve Board are: engaging in open market transactions in U. S. Government securities, changing the discount rate on bank borrowings, changing reserve requirements against bank deposits, prohibiting the payment of interest on demand deposits, and imposing conditions on time and savings deposits. These techniques are used in varying combinations to influence the overall growth of bank loans, investments and deposits. Their use may also affect interest rates charged on loans or paid on deposits. The effect of governmental policies on the earnings of the Company cannot be predicted. However, the Company’s earnings will be impacted by movement in interest rates, as discussed in Item 7A. “Quantitative and Qualitative Disclosures About Market Risk.”

Employees

At December 31, 2004, the Company and the Bank had 362 employees, of whom 71 were officers, 231 were full-time employees and 60 were part-time employees. The Company believes it has a favorable relationship with its employees. See Part III, Item 10 for a description of the executive officers of the Company.

ITEM 2. PROPERTIES

The Company owned the following properties, which had a combined book value of $3.3 million at December 31, 2004:

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The Company leased the following facilities at an aggregate annual rental of $2.5 million as of December 31, 2004:

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ITEM 3. LEGAL PROCEEDINGS

The Company may be party to legal actions that are routine and incidental to its business. In management’s opinion, the outcome of these matters, individually or in the aggregate, will not have a material impact on the results of operations or financial position of the Company.

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

There were no matters submitted to a vote of the stockholders during the quarter ended December 31, 2004.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND

ISSUER PURCHASES OF EQUITY SECURITIES

The Company’s Common Stock is traded on the National Association of Securities Dealers’ Automated Quotation System (“Nasdaq^®”) National Market tier of The Nasdaq Stock Market^SM under the symbol “CBMD.”

As a depository institution whose deposits are insured by the FDIC, the Bank may not pay dividends or distribute any of its capital assets while it remains in default on any assessment due the FDIC. The Bank currently is not in default under any of its obligations to the FDIC. As a commercial bank under the Maryland Financial Institution Law, the Bank may declare cash dividends from undivided profits or, with the prior approval of the Commissioner of Financial Regulation, out of surplus in excess of 100% of its required capital stock, and after providing for due or accrued expenses, losses, interest and taxes.

The Company and the Bank, in declaring and paying dividends, are also limited insofar as minimum capital requirements of regulatory authorities must be maintained. The Company and the Bank currently comply with such capital requirements.

Dividends declared per share on the Company’s common stock were $.62 in 2004, $.525 in 2003, and $.455 in 2002, representing a payout ratio of 33.32% in 2004, 31.51% in 2003 and 29.72% in 2002. The dividend payout ratio is the result of dividing the amount of dividends paid by net income. Management believes a normal payout ratio to be in a range between 25% and 40% of net income.

On December 22, 2004, the Board of Directors of the Bank authorized a cash dividend of $1.4 million to be paid to the Company on January 20, 2005. In addition, on December 22, 2004, the Board of Directors of the Company declared a $.17 per share cash dividend to shareholders of common stock of record on January 7, 2005, payable January 20, 2005.

During 2004, the Company repurchased and retired 93,546 shares of common stock at an average price of $28.56 per share, pursuant to the Company’s stock repurchase program approved in October 2000. During 2002, the Company repurchased and retired 10,000 shares of common stock at an average price of $15.82 per share, pursuant to the Company’s 2000 stock repurchase program. No stock was purchased under this program in 2003. At December 31, 2004, the Company was authorized to repurchase up to 320,000 additional shares under this program. The excess of the purchase price over the par value of shares repurchased is applied to reduce additional paid-in capital.

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The following table presents high and low sale prices and dividends per share of the Company’s Common Stock for the periods indicated.

As of December 31, 2004, there were 935 common stockholders of record holding an aggregate of 7,114,267 shares. The Company believes there to be in excess of 3,200 beneficial owners of the Company’s Common Stock.

The following table presents the number of shares of the Company’s Common Stock that the Company repurchased during the quarter ended December 31, 2004 under the October 2000 stock repurchase plan and the average price paid per share purchased.

In February 2005, the Company repurchased 218,345 shares of common stock in a private transaction with an unaffiliated third party at $32.20 per share under the 2000 stock repurchase plan at a total cost of $7.0 million.

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ITEM 6. SELECTED FINANCIAL DATA

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

The Company continued to build upon its strong past performance achieving another year of record earnings in 2004. Net income for the year ended December 31, 2004 was $13.3 million, or $1.80 per diluted share, representing an increase of 11.6% over the $11.9 million, or $1.62 per diluted share reported for the comparable period in 2003. The Company’s return on average equity improved to 14.88% for 2004 from 14.63% for 2003. Return on average assets was 1.21% for 2004, compared to 1.22% for 2003.

The past year was a great success in many respects; however, there were several factors that were key to the overall strength in the Company’s performance. Loan growth, combined with a stable net interest margin and moderate increases in noninterest expenses were critical to the Company’s success during 2004. Equally important was asset quality, as the Company realized its second consecutive year of net loan loss recoveries.

Loan demand throughout the Company’s primary service area during 2004 resulted in an increase in total loans outstanding of $114.4 million or 13.7% at December 31, 2004 compared to balances at December 31, 2003. The Company continued to focus on its niche in the residential construction and residential land acquisition and development markets during the year as the local economy remained strong and the interest rate environment was favorable to business expansion. The result was a $61.8 million or 21.8% increase to $345.4 million in real estate development and construction loans outstanding at December 31, 2004 as compared to December 31, 2003. Total commercial real estate loans also increased 14.1% to $164.0 million and retail loans, primarily consisting of home equity loans and personal loans secured by second mortgages, also grew by 15.9% to $196.2 million at December 31, 2004. While the Baltimore/Washington Corridor provides a strong and opportunistic market, the Company’s niche allows it to effectively compete not only in the counties of the Baltimore/Washington corridor, but other Maryland counties, the District of Columbia and targeted markets in contiguous states. Historically, strength in the residential real estate market has been cyclical and influenced by numerous external forces. Therefore, the Company believes future demand for real estate loans will be largely influenced by interest rates and general economic conditions.

The net interest margin is a critical component affecting the performance of the Company. During 2004, the Federal Reserve increased its targeted federal funds rate by 125 basis points during the period June 30, 2004 through December 31, 2004. The Company’s fully tax-equivalent net interest margin increased slightly to 4.44% for the twelve months ended December 31, 2004 as compared to 4.42% for the twelve months ended December 31, 2003. A relatively constant average cost of funds year over year was achieved, in large part, due to the Company’s continued focus on funding loan growth with customer-based funding sources. These sources are principally retail and commercial deposits and also short-term borrowings from customers in the form of commercial paper and repurchase agreements. This funding emphasis is significant as growth of the Company is primarily achieved through core products and services. Equally significant is the Company’s ability to manage the overall cost of funds by attracting and maintaining lower cost, relationship-based funding. Total customer funding, including deposits, of $1.03 billion at December 31, 2004, represents a 15.5% or $137.5 million increase compared to December 31, 2003 balances. An increase in total deposits of 15.9% or $125.0 million to $912.6 million at December 31, 2004 compared to December 31, 2003 contributed to the overall increase in total customer funding. Growth in noninterest-bearing demand deposits of 24.1% provided 36.2%, or $49.8 million, of the increase in total customer funding. Certificates of deposit also increased $72.8 million, or 24.7%, during 2004.

The Company experienced a decline in noninterest income during 2004 primarily due to a decrease in residential mortgage refinancing activity relative to 2003 and 2002 production levels. Gains and fees on the sales of mortgage loans increased from $2.1 million in 2002 to $3.0 million in 2003. However, gains and fees on the sales of mortgage loans decreased to $1.4 million in 2004. Noninterest income was also impacted by a $276,000 decline in fees charged for services as the volume of overdraft account charges decreased during the year and other income decreased $373,000 due to non-recurring fees recognized upon the prepayment of certain large lending relationships during 2003.

The Company continued to leverage its overhead structure by limiting the increase in total noninterest expenses to $1.1 million, or 3.6%, for 2004 as compared to 2003, while operating income (net interest income plus noninterest income) increased $2.8 million or 5.5%. The increase in noninterest expense during the year included: (i) an increase of $480,000, or 2.9%, in salaries and employee benefits; (ii) an increase in occupancy costs of $132,000, or 3.5%, reflecting normal escalations in lease payments and costs to maintain business properties; (iii) an increase in professional fees of $282,000, or 42.5%, primarily reflecting added consulting, legal and audit expenses related to Sarbanes-Oxley compliance; and (iv) an increase of $321,000 in other noninterest expenses due to added costs incurred to support increases in loan and deposit processing volumes.

While the Company continued to experience growth in its loan portfolio, asset quality remained very solid as evidenced by a reduction in nonperforming assets and past due loans to $645,000 at December 31, 2004. As a percent of total assets, non-performing assets and past due loans at December 31, 2004 were .05% compared to .09% at December 31, 2003. At December 31, 2004, the allowance for credit losses totaled $11.6 million, or 1.22% of total loans, compared to $10.8 million, or 1.30% of loans, at December 31, 2003. The Company recorded net recoveries $27,000 during 2004 and $819,000 during 2003.

The discussion that follows provides further detailed analysis regarding the Company’s financial condition and results of operations. It is intended to assist readers in their analysis of the accompanying consolidated financial statements and notes thereto.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

CRITICAL ACCOUNTING ESTIMATES

The Company’s consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and follow general practices within the banking and financial services industry. The application of these accounting principles requires management to make estimates, judgments, and assumptions based upon information available at the time the financial statements are prepared, and affect the amounts reported in the financial statements and the accompanying notes. Accordingly, as this information changes, future financial statements could reflect different results, estimates, judgments, and assumptions. Critical accounting policies are those that are both important to the presentation of the Company’s financial condition and results of operations and require management’s most difficult, complex or subjective judgments due to their inherent reliance on the use of estimates and assumptions. The Company’s critical accounting policies relate to the determination of the allowance for credit losses (the “Allowance”), other than temporary impairment of investment securities and deferred tax assets.

The Company provides for credit losses through the establishment of the Allowance. The Company’s objective is to ensure that the Allowance is a reasonable estimate of probable credit losses inherent in the loan portfolio at the date of each statement of condition. Management considers a number of factors in estimating the required level of the Allowance. These factors include: historical loss experience in the loan portfolios; the levels and trends in past-due and nonaccrual loans; the status of nonaccrual loans and other loans identified as having the potential for further deterioration; credit risk and industry concentrations; trends in loan volume; the effects of any changes in lending policies and procedures or underwriting standards; and a continuing evaluation of the economic environment. The Company’s estimate of the required Allowance is subject to revision as these factors change and is sensitive to the effects of economic and market conditions on borrowers.

Securities are evaluated periodically to determine whether a decline in their value is other than temporary. The term “other than temporary” is not intended to indicate a permanent decline in value. Rather, it means that the prospects for near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Management reviews criteria such as the magnitude and duration of the decline, as well as the reasons for the decline, to predict whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

The Company accounts for income taxes under the asset/liability method. Deferred tax assets are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period indicated by the enactment date. A valuation allowance is established for deferred tax assets when, in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. The judgment about the level of future taxable income is dependent to a great extent on matters that may, at least in part, be beyond the Company’s control. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred tax assets could change in the near term.

INCOME STATEMENT ANALYSIS

Net Interest Income

Net interest income, the amount by which interest income on interest-earning assets exceeds interest expense on interest-bearing liabilities, is the most significant component of the Company’s earnings. Net interest income is a function of several factors, including changes in the volume and mix of interest-earning assets and funding sources, and market interest rates. While management policies influence these factors, external forces, including customer needs and demands, competition, the economic policies of the federal government and the monetary policies of the Federal Reserve Board, are also important.

The following table sets forth, for the periods indicated, information regarding the average balances of interest-earning assets and interest-bearing liabilities, the amount of interest income and interest expense, and the resulting yields on average interest-earning assets and rates paid on average interest-bearing liabilities. Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)