EX-13 3 0003.txt DNB Financial Corporation and Subsidiary Corporate Profile Downingtown National Bank is Chester County's oldest, locally-owned, independent commercial bank. We have been an important part of our community earning Chester County's trust since 1861. We've seen 28 United States presidents, starting with Abraham Lincoln, seven wars and over 51,000 sunrises. Our guiding principle throughout the years has been to do the right thing for our customers. We believe in good old-fashioned values: character, integrity, honesty and loyalty . . . yes we're traditional - it's what our customers want, and it's why we've remained independent for 140 years. We have a thoughtful approach to making changes that impact our customers - lots of things change and it can be unsettling. Your Bank should be a constant provider of financial services, regardless of changes in markets and technology. We remain committed to building solid banking relationships, to providing excellent customer service and to achieving above average returns for our stockholders. As involved citizens, we donate our services, volunteer our skills, and commit charitable resources toward improving the community in which we live and work. Table of Contents 1 Selected Financial Data 2 Letter to Shareholders 4 Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Market for Common Stock 20 Consolidated Financial Statements and Notes 39 Corporate Information DNB FINANCIAL CORPORATION AND SUBSIDIARY Selected Financial Data (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
At or For the Year Ended December 31 2000 1999 1998 1997 1996 ======================================================================================================================= RESULTS OF OPERATIONS Interest income $ 23,752 $ 20,500 $ 17,903 $ 16,364 $ 15,162 Interest expense 12,790 9,825 8,266 6,984 6,459 ----------------------------------------------------------------------------------------------------------------------- Net interest income 10,962 10,675 9,637 9,380 8,703 Provision for loan losses -- -- -- -- -- Non-interest income 1,740 1,634 1,506 1,283 1,004 Non-interest expense 8,931 8,231 6,969 7,083 6,731 ----------------------------------------------------------------------------------------------------------------------- Income before income taxes 3,771 4,078 4,174 3,580 2,976 ----------------------------------------------------------------------------------------------------------------------- Income tax expense 1,063 1,246 1,252 865 658 ----------------------------------------------------------------------------------------------------------------------- Net income $ 2,708 $ 2,832 $ 2,922 $ 2,715 $ 2,318 ----------------------------------------------------------------------------------------------------------------------- PER SHARE DATA* Basic earnings $ 1.60 $ 1.68 $ 1.74 $ 1.62 $ 1.38 Diluted earnings 1.58 1.63 1.67 1.58 1.37 Cash dividends 0.50 0.47 0.41 0.36 0.22 Book value 13.73 12.20 12.26 10.92 9.65 Weighted average Common shares outstanding 1,691,477 1,683,863 1,680,745 1,680,255 1,680,255 FINANCIAL CONDITION Total assets $356,670 $301,349 $265,418 $219,451 $207,128 Loans, less unearned income 191,201 171,456 148,726 129,954 121,573 Allowance for loan losses 4,917 5,085 5,205 5,281 5,112 Deposits 290,791 254,881 225,373 199,237 178,424 Stockholders' equity 23,230 20,538 20,606 18,356 16,216 SELECTED RATIOS Return on average stockholders' equity 12.64% 13.66% 15.13% 15.77% 15.35% Return on average assets 0.83 0.99 1.22 1.29 1.18 Average equity to average assets 6.60 7.28 8.07 8.21 7.65 Loans to deposits 65.75 67.27 65.99 65.22 68.14 Dividend payout ratio 30.93 28.07 23.85 22.41 15.63 ======================================================================================================================= * Per share data and shares outstanding have been adjusted for the 2 for 1 stock split in September 1997 and for the 5% stock dividends in December of 2000, 1999, 1998, 1997 and 1996. ======================================================================================================================= [GRAPHICS OMITTED -BAR CHARTS OF NET INCOME, DEPOSITS AND LOANS, 1996-2000] Downingtown National Bank [LOGO] 1
DNB FINANCIAL CORPORATION AND SUBSIDIARY Letter to Shareholders ================================================================================ [GRAPHIC OMITTED - PHOTO OF HENRY F. THORNE] March 24, 2001 Dear Fellow Shareholder: In my Letter to Shareholders last year, I indicated that 2000 would be another challenging one for the Bank. As the year unfolded, it became clearer that unrelenting competition in the marketplace for loans and deposits would put increased pressure on our net interest margin. In addition, the full-year's effect of expenses related to branch expansion and continued implementation of our Technology Plan had an unfavorable impact on earnings. While overall earnings were down approximately 4% from 1999, we believe that we are laying the groundwork for a more diverse and sustainable revenue stream for the future, which is designed to enhance the value of your Bank. During 2000, the Bank earned $2.7 million or $1.58 per diluted share, compared to a profit of $2.8 million, or $1.63 per diluted share, in 1999. Our successful business development efforts for both personal and corporate lines of business produced a 16% increase in interest income. Loan demand remained strong throughout the year, and loan growth of 12% helped fuel the increase in interest income. However, competitive pressures caused yields to be lower than we had planned. Loan growth was funded by a robust 14% growth in deposits, which reflected new deposits from our West Goshen and Kennett Square offices. The deposit growth also reflected a marketing strategy of promoting our Premier Money Market Account as an attractive alternative to short term Certificates of Deposit and non-FDIC insured money market investments. While we were very pleased with the strong deposit growth, interest expense for these new deposits was high. The good news is that these core deposits provide a more stable funding source, and they should afford many opportunities for cross selling of other Bank services. For the coming year, we plan to moderate the growth in deposits and focus on lowering our cost of funds by changing the deposit mix. In addition to the challenge of regaining earnings momentum, 2000 presented the Bank with other challenges as well. The planned opening of our new Exton office ran into unexpected delays. However, we are pleased that the project is back on track, construction is well underway, and we plan to be open for business in the beginning of the third quarter. Our Internet Banking solution, called "e-Access Banking", went "live" on February 20, 2001. We are confident that our efforts have produced an attractive web site that has excellent functionality and ease of use. Early feedback from our customers has been very positive, and 2 Downingtown National Bank [LOGO] Letter to Shareholders -------------------------------------------------------------------------------- we plan an ongoing effort to improve the site by adding additional features and benefits. Our plan to introduce a variety of non-traditional banking services to our customers became a reality on March 6, 2001 when we completed our initial implementation efforts. A new Bank subsidiary, DNB Financial Services, Inc. -- a Pennsylvania licensed insurance agency, was formed. This new entity will enable us to offer a full range of securities and insurance products, including long-term care and life insurance, annuities, mutual funds, and other personal and business products. In addition, we have developed strategic alliances with the American Financial Group, a well regarded local financial advisor and insurance broker, and Walnut Street Securities, a registered broker-dealer. We have been actively involved for the past several months in the process of licensing and training our staff and in developing targeted marketing programs for the introduction of these exciting new services. Earlier in the year, Charles E. Bradford joined the Bank as Director of our Trust and Investment Group. Charlie's strong background in investment management and business development will enable us to grow our wealth management business. We believe there is a great need in our marketplace for the level of high quality, personal service we can bring to a client relationship. The Bank's Trust and Investment Group will emphasize a strong client focus, improved service quality and expert advice through key alliances with well-regarded, local money managers. During the summer, we completed our annual strategic planning process, which identified several key strategic objectives that form a framework designed to enhance shareholder value. Going forward, we plan to reduce our reliance on net interest income, in large measure by focusing efforts to grow our wealth management business. We are working to establish a sales and service culture in the Bank that will build on our strengths as a community bank while improving our ability to identify and meet customer needs. We plan to continue our investment in our employees by providing more training and by improving the environment for individual achievement and success. We believe that these steps will enhance our presence throughout Chester County and the value of your investment. Shortly before writing this, the Federal Reserve Bank's Open Market Committee lowered interest rates for the second time in 2001. At this point, all indications point to further easing in 2001 in view of the weakening economy and the lowering of consumer confidence. Despite the slow down in the economy, we are beginning the New Year with a great deal of momentum, and we are working hard to produce a great year. Thank you as always for your support. We will continue our efforts to reward your loyalty. Sincerely, /S/ Henry F. Thorne Henry F. Thorne President and Chief Executive Officer Downingtown National Bank [LOGO] 3 Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion provides an overview of the financial condition and results of operations of DNB Financial Corporation (the "Corporation" or "DNB") and its wholly owned subsidiary, Downingtown National Bank (the "Bank"), a community bank providing personal and business banking as well as trust and investment services. DNB is managed as a single operating segment. This discussion should be read in conjunction with the Corporation's consolidated financial statements presented elsewhere in this annual report. Results of Operations Summary of Performance For the year ended December 31, 2000, DNB reported net income of $2.7 million or $1.58 per share on a diluted basis. This represents a $124,000 or 4% decrease from $2.8 million or $1.63 per share in 1999. Earnings before taxes decreased $307,000 or 8% to $3.8 million from $4.1 million in 1999. For the year ended December 31, 1998, net income was $2.9 million or $1.67 per share, and income before taxes was $4.2 million. Interest income grew $3.3 million or 16% to $23.8 million for the year ended December 31, 2000. Significant growth in loans and investments contributed to the increase over the prior year. Interest expense increased $3.0 million or 30% to $12.8 million for the year ended December 31, 2000. Interest bearing liabilities grew by $45.9 million or 19%. Net interest income increased by $287,000 or 3% to $11.0 million in 2000 compared to $10.7 million and $9.6 million in 1999 and 1998, respectively. Non-interest income was $1.7 million for the year ended December 31, 2000. Non-interest income for 1999 and 1998 was $1.6 million and $1.5 million, respectively. The $106,000 or 7% increase in 2000 resulted from increased service charges and other fee income. Non-interest expense was $8.9 million for the year ended December 31, 2000. This represented a $700,000 or 9% increase from $8.2 million in 1999. Non-interest expense in 1998 was $7.0 million. The significant increase in 2000 can be attributed to increased expenditures in two major categories. DNB's salaries & employee benefits expense increased $478,000 or 11% year over year. This expected increase reflects staff additions for several e-business initiatives as well as the full year's expenses related to branch expansion. Occupancy expenses climbed $103,000 or 20% as a result of a full year's depreciation on several significant hardware and software upgrades that took place throughout 1999 and the full year's impact of two branches opened during 1999. Net Interest Income DNB's earnings performance is primarily dependent upon its level of net interest income, which is the excess of interest revenue over interest expense. Interest revenue includes interest earned on loans (net of interest reversals on non-performing loans), investments, Federal funds sold and interest-earning cash, as well as net loan fee amortization and dividend income. Interest expense includes the interest cost for deposits, FHLB advances, Federal funds purchased and other borrowings. During 2000, net interest income increased, on a tax equivalent basis, $329,000 or 3% to $11.2 million, from $10.9 million in 1999. As shown in the Rate/Volume Analysis below, the increase in net interest income during 2000 was due to the positive effects of changes in volume, which was partially offset by the negative effects of rate changes. The increased volume resulted from significant loan, investment and Federal funds growth, which exceeded interest-bearing liability growth by $1.7 million. Average loan balances for 2000 rose $15.1 million and average investment securities rose $21.9 million. The impact from higher volumes of earning assets amounted to an increase of $3.3 million in interest income. Average NOW, money market and savings accounts increased a total of $10.9 million. Average time deposits increased $14.7 million ($8.0 million from deposits over $100,000) and borrowings increased on average $9.4 million (FHLB advances and Federal funds purchased). The net impact on earn- 4 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- ings of higher volumes of interest-bearing liabilities amounted to $1.7 million, partially offsetting the impact from the increased volume of interest-earning assets. The overall impact of rate changes amounted to a negative $713,000, reflecting strong competition for loans as well as deposits. Rising interest rates also negatively impacted earnings as DNB's deposits repriced earlier while loans and investments lagged. As a result of these rate pressures, DNB experienced declines in both its net interest spread and net interest margin. During 1999, net interest income increased, on a tax equivalent basis, $1.2 million or 12% to $10.9 million, from $9.7 million in 1998. As shown in the Rate/Volume Analysis below, the increase in net interest income during 1999 was due to the positive effects of changes in volume, which was partially offset by the negative effects of rate changes. The increased volume resulted from significant loan and investment growth, which exceeded interest-bearing liability growth by $3.0 million, aided in part by an increase in non-interest bearing demand balances of $4.8 million. Average loan balances for 1999 rose $24.9 million, while average investment securities rose $25.9 million and Federal funds sold were down $8.2 million. The impact from higher volumes of earning assets amounted to an increase of $3.4 million in interest income. Average NOW, money market and savings accounts increased a total of $21.8 million. Average time deposits increased $7.5 million ($3.0 million from public deposits over $100,000) and borrowings increased on average $10.3 million. The net impact on earnings of higher volumes of interest-bearing liabilities amounted to $1.5 million, partially offsetting the impact from the increased volume of interest-earning assets. The overall impact of rate changes amounted to a negative $624,000. The following tables set forth, among other things, the extent to which changes in interest rates and changes in the average balances of interest-earning assets and interest-bearing liabilities have affected interest income and expense during 2000 and 1999 (tax-exempt yields and yields on agency-preferred stock that have a 70% divi- --------------------------------------------------------------------------------
Rate / Volume Analysis (Dollars in thousands) 2000 Versus 1999 1999 Versus 1998 ---------------------------------------------------------------- Change Due To Change Due To Rate Volume Total Rate Volume Total ====================================================================================================================== Interest-earning assets: Loans $ (48) $1,279 $1,231 $(394) $2,097 $1,703 Investment securities: Taxable 523 1,272 1,795 (156) 1,103 947 Tax-exempt (6) 76 70 3 588 591 Tax-preferred DRD -- 135 135 -- -- -- Federal funds sold 84 (21) 63 (52) (420) (472) ====================================================================================================================== Total $ 553 $2,741 $3,294 $(599) $3,368 $2,769 ====================================================================================================================== Interest-bearing liabilities: Time deposits $ 550 $ 823 $1,373 $(239) $ 341 $ 102 NOW, money market and savings deposits 532 350 882 183 655 838 FHLB advances 184 492 676 5 539 544 Federal funds purchased -- 9 9 -- -- -- Other borrowings -- 25 25 76 -- 76 ====================================================================================================================== Total 1,266 1,699 2,965 25 1,535 1,560 ====================================================================================================================== Net interest income $ (713) $1,042 $ 329 $(624) $1,833 $1,209 ====================================================================================================================== Downingtown National Bank [LOGO] 5
Management's Discussion and Analysis -------------------------------------------------------------------------------- dend received deduction ("DRD") have been adjusted to a tax equivalent basis using a 34% tax rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (i) changes in rate (change in rate multiplied by old volume) and (ii) changes in volume (change in volume multiplied by old rate). The net change attributable to the combined impact of rate and volume has been allocated proportionately to the change due to rate and the change due to volume. The following table provides, for the periods indicated, information regarding: (i) DNB's average balance sheet; (ii) the total dollar amounts of interest income from interest-earning assets and the resulting average yields (tax-exempt yields and yields on agency preferred stock that have a -------------------------------------------------------------------------------- Average Balances, Rates, and Interest Income and Expense (Dollars in thousands)
Year Ended December 31 ---------------------------------------------------------------------------------------------- 2000 1999 1998 ---------------------------------------------------------------------------------------------- Average Yield/ Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate Balance Interest Rate =========================================================================================================================== ASSETS Interest-earning assets: Investment securities: Taxable $112,629 $ 7,641 6.78% $ 93,441 $ 5,846 6.26% $ 75,714 $ 4,899 6.47% Tax-exempt 10,502 744 7.08 9,423 674 7.16 1,201 83 6.91 Tax-preferred DRD 1,677 135 8.05 -- -- -- -- -- -- --------------------------------------------------------------------------------------------------------------------------- Total securities 124,808 8,520 6.83 102,864 6,520 6.34 76,915 4,982 6.48 Federal funds sold 7,114 448 6.30 7,572 385 5.08 15,766 857 5.44 Total loans 178,190 15,056 8.45 163,053 13,825 8.48 138,171 12,154 8.80 --------------------------------------------------------------------------------------------------------------------------- Total interest-earning assets 310,112 24,024 7.75 273,489 20,730 7.58 230,852 17,993 7.79 Non-interest-earning assets 14,643 11,376 8,398 --------------------------------------------------------------------------------------------------------------------------- Total assets $324,755 $284,865 $239,250 =========================================================================================================================== LIABILITIES AND STOCKHOLDERS' EQUITY Interest-bearing liabilities: NOW, money market and savings deposits $121,037 $ 4,239 3.50% $110,180 $ 3,357 3.05% $ 88,384 $ 2,519 2.85% Time deposits 116,465 6,751 5.80 101,741 5,378 5.29 94,247 5,276 5.60 --------------------------------------------------------------------------------------------------------------------------- Total interest-bearing deposits 237,502 10,990 4.63 211,921 8,735 4.12 182,631 7,795 4.27 Federal funds purchased 171 9 5.26 -- -- -- -- -- -- Other borrowings 28,656 1,791 6.25 19,470 1,090 5.60 9,127 471 5.16 --------------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 266,329 12,790 4.80 231,391 9,825 4.25 191,758 8,266 4.31 Demand deposits 35,390 31,379 26,588 Other liabilities 1,604 1,362 1,592 Stockholders' equity 21,432 20,733 19,312 --------------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $324,755 $284,865 $239,250 =========================================================================================================================== Net interest income $11,234 $10,905 $ 9,727 =========================================================================================================================== Interest rate spread 2.95% 3.33% 3.48% =========================================================================================================================== Net interest margin 3.62% 3.99% 4.21% ===========================================================================================================================
6 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- 70% dividend received deduction ("DRD") have been adjusted to a tax equivalent basis using a 34% tax rate); (iii) the total dollar amounts of interest expense on interest-bearing liabilities and the resulting average costs; (iv) net interest income; (v) net interest rate spread; and (vi) net interest margin. Average balances were calculated based on daily balances. Nonaccrual loan balances are included in total loans. Loan fees and costs are included in interest on total loans. Provision for Loan Losses To provide for known and inherent losses in the loan portfolio, DNB maintains an allowance for loan losses. To maintain an adequate allowance, management charges the provision for loan losses against income. There were no provisions made during the three years ended December 31, 2000, since management determined the allowance for loan losses was adequate based on its analysis. Net loan charge-offs were $168,000 in 2000, compared to $120,000 and $76,000 in 1999 and 1998, respectively. The percentage of net charge-offs to total average loans was 0.09%, 0.07% and 0.06% during the same respective periods. Another measure of the adequacy of the allowance is the coverage ratio of the allowance to non-performing loans, which has been in excess of 165% during this three year period. In addition, the ratio of non-performing loans to total loans has steadily declined during the period. Non-Interest Income Total non-interest income includes service charges on deposit products; fees received by DNB's Trust & Investment Group; and other sources of income such as net gains on sales of investment securities and other real estate owned ("OREO") properties. In addition, DNB receives fees for cash management, merchant services, debit cards, safe deposit box rentals, check cashing, lock box services and similar activities. Non-interest income was $1.7 million in 2000, compared to $1.6 million in 1999 and $1.5 million in 1998. Service charges on deposit accounts increased $128,000 or 20% to $755,000 in 2000 from $627,000 in 1999 and $515,000 in 1998. Much of the increase in this category came from non-sufficient funds ("NSF") fees, which rose $90,000, due to an increase in the volume of accounts as well as a concerted effort by management to reduce the percentage of fees waived on deposit account overdrafts. Income from DNB's Trust & Investment Group was $448,000 in 2000, compared to $399,000 in 1999 and $430,000 in 1998. The $49,000 or 12% increase in 2000 was due to a higher volume of commissions earned on estate settlements. Other non-interest income declined by $71,000 or 12% to $537,000 for the year ended December 31, 2000, from $608,000 in 1999. Other non-interest income was $556,000 in 1998. DNB recognized net gains of $159,000 and $162,000 on the sales of several OREO properties during 1999 and 1998 respectively, while there were no such sales during 2000. This negative variance was offset by a $41,000 increase in DNB's Visa(R) Debit Card commissions during 2000. Non-Interest Expense Non-interest expense includes salaries & employee benefits, furniture & equipment, occupancy, professional & consulting fees as well as marketing, printing & supplies and other less significant expense items. Non-interest expenses were $8.9 million in 2000, compared to $8.2 million and $7.0 million in 1999 and 1998, respectively. The $700,000 or 9% increase was due to higher levels of expenses in several categories as discussed below. Salaries & employee benefits expense totaled $4.7 million in 2000, compared to $4.3 million in 1999 and $3.9 million in 1998. Salary & employee benefits expense for 2000 increased as a result of a full year's staffing for two new branches opened in 1999, several new positions created for e-business initiatives, as well as normal merit increases. The increase in salary & employee benefits expense during 1999 over 1998 resulted from more full-time equivalent employees due to two new branches opened in 1999. Furniture & equipment expense includes depreciation, rent, maintenance and miscellaneous purchases of office equipment and furniture. Downingtown National Bank [LOGO] 7 Management's Discussion and Analysis -------------------------------------------------------------------------------- Furniture & equipment expense increased $102,000 or 11% to $1.0 million during 2000, compared to $927,000 in 1999 and $711,000 in 1998. The increase in this category during 2000 is attributable to a full year's depreciation on several significant hardware and software upgrades that took place throughout 1999 and the full year's impact of two branches opened during 1999. Furniture, fixtures & equipment and maintenance agreements increased $34,000 and $36,000, respectively. The significant increase in 1999 over 1998 was attributable to new computer hardware & software purchased at the end of 1998 and depreciated for a full year in 1999. Depreciation on this equipment totaled $195,000 and accounted for substantially all of the increase. Occupancy expense includes office building depreciation, rent, taxes, maintenance and utilities. Occupancy expense totaled $622,000 in 2000, compared to $519,000 in 1999 and $438,000 in 1998. The increase in this category during 2000 and 1999 related to higher levels of repairs & depreciation for two offices opened in 1999. Professional & consulting expense includes fees for legal, audit & accounting and asset/liability management services as well as consulting fees for technology, human resources and other special projects. Professional & consulting expense for 2000 was $533,000, compared to $492,000 in 1999 and $347,000 in 1998. Legal expenses declined $68,000 to $185,000 in 2000 due to fewer one-time legal expenses in 2000 (such as legal advice on new branches or loan workouts). Outside service fees increased $117,000 to $262,000 due to additional expenditures for direct marketing assistance and a decision to outsource loan review. The significant increase in 1999 over 1998 related to costs incurred for legal and other professional services associated with opening new branches during the year, as well as services provided by technology consultants in connection with DNB's equipment upgrade. Marketing expense declined $107,000 or 25% to $315,000 in 2000 primarily due to less expenditures for branch openings and human resource recruiting. Marketing expense increased $144,000 to $422,000 for the year ended December 31, 1999, compared to $278,000 in 1998. Marketing increased, generally, due to the addition of the Kennett Square and West Goshen branches. Grand opening celebrations, direct mailings, brochures and general advertising accounted for approximately $74,000, while new employee recruitment amounted to $70,000. Printing & supplies declined $5,000 to $278,000 in 2000. This expense increased $115,000 or 68% to $283,000 in 1999, compared to $168,000 in 1998. The significant increase in 1999 was due to expenditures for flyers, posters, mailers and supplies relating to the Kennett Square Branch purchase in March 1999 and the opening of the West Goshen Office in May. In addition, mailings and new brochures relating to the re-alignment of all of DNB's checking products during the second quarter of 1999 contributed to the increase. Other expenses include such items as postage, insurance, director fees, appraisal fees, telephone and other miscellaneous expenses. Other expenses increased $88,000 or 7% to $1.4 million in 2000. This compares to $1.3 million and $1.1 million in 1999 and 1998. The increase in 2000 and 1999 relates to the aforementioned technology upgrades and branch expansion. The largest single increase in this category during 1999 was telephone and fax expense which increased $74,000 due to the increased number and higher quality of communication lines required to support the new technology. Income Taxes Income tax expense was $1.1 million in 2000, $1.2 million in 1999 and $1.3 million in 1998. DNB's effective tax rate was 28%, 31%, and 30% for the three years, respectively. The effective tax rates in all years were less than the statutory rate due to the effect of tax exempt income. 2000's rate was also effected by tax credits recognized on a low-income housing limited partnership and DNB's participation in bank-owned life insurance investments. 8 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- Financial Condition Analysis Investment Securities DNB's investment portfolio consists of US agency securities, mortgage-backed securities issued by US Government agencies, corporate bonds, collateralized mortgage obligations, asset-backed securities, state and municipal securities, agency and bank stocks, commercial paper and other bonds and notes. In addition to generating revenue, DNB maintains the investment portfolio to manage interest rate risk, provide liquidity, provide collateral for borrowings and to diversify the credit risk of earning assets. The portfolio is structured to maximize DNB's net interest income given changes in the economic environment, its liquidity position and balance sheet mix. Given the nature of the portfolio, and its generally high credit quality, management expects to realize all of its investment upon the maturity of such instruments, and believes that any market value decline is temporary in nature. Management determines the appropriate classification of securities at the time of purchase. Investment securities are classified as: (a) securities held to maturity ("HTM") based on management's intent and ability to hold them to maturity; (b) trading account ("TA") securities that are bought and held principally for the purpose of selling them in the near term; and (c) securities available for sale ("AFS"). DNB does not currently maintain a trading account portfolio. Securities classified as AFS include securities that may be sold in response to changes in interest rates, changes in prepayment assumptions, the need to increase regulatory capital or other similar requirements. DNB does not necessarily intend to sell such securities, but has classified them as AFS to provide flexibility to respond to liquidity needs. ------------------------------------------------------------------------------- Investment Maturity Schedule, Including Weighted Average Yield (Dollars in thousands)
December 31, 2000 Less than Over No Stated Held to Maturity 1 Year 1-5 Years 5-10 Years 10 Years Maturity Total Yield ======================================================================================================================= US Government agency obligations $-- $ 4,000 $7,995 $ 7,810 $-- $19,805 7.52% Collateralized mortgage obligations -- -- -- 16,047 -- 16,047 6.24 US agency mortgage-backed securities 191 40 199 1,731 -- 2,161 6.45 Equity securities -- -- -- -- 3,316 3,316 7.05 Other securities -- -- -- 999 -- 999 6.04 ----------------------------------------------------------------------------------------------------------------------- Total $ 191 $ 4,040 $8,194 $26,587 $3,316 $42,328 ======================================================================================================================= Percent of portfolio 1% 10% 19% 63% 7% 100% ======================================================================================================================= Weighted average yield 3.9% 7.0% 7.7% 6.4% 7.1% 6.8% ======================================================================================================================= Less than Over No Stated Available for Sale 1 Year 1-5 Years 5-10 Years 10 Years Maturity Total Yield ======================================================================================================================= US Government agency obligations $5,984 $ 6,430 $1,602 $13,547 $-- $27,563 6.54% Corporate bonds -- 5,007 1,940 23,498 -- 30,445 7.48 State and municipal tax-exempt -- -- -- 9,724 -- 9,724 7.31 US agency mortgage-backed securities 453 1,137 -- 3,844 -- 5,434 6.82 DRD agency preferred stock -- -- -- -- 6,020 6,020 8.06 Other securities -- 1,569 3,382 1,951 -- 6,902 6.75 ----------------------------------------------------------------------------------------------------------------------- Total $6,437 $14,143 $6,924 $52,564 $6,020 $86,088 ======================================================================================================================= Percent of portfolio 7% 16% 8% 62% 7% 100% ======================================================================================================================= Weighted average yield 5.3% 6.7% 6.6% 7.4% 8.1% 7.1% ======================================================================================================================= Downingtown National Bank [LOGO] 9
Management's Discussion and Analysis --------------------------------------------------------------------------------
Composition of Investment Securities (Dollars in thousands) December 31 --------------------------------------------------------------------- 2000 1999 --------------------------------------------------------------------- Held to Available Held to Available Maturity for Sale Maturity for Sale ======================================================================================================================= US Government agency obligations $19,805 $27,563 $14,203 $18,663 Corporate bonds -- 30,445 -- 20,493 Collateralized mortgage obligations 16,047 -- 19,608 -- State and municipal tax-exempt -- 9,724 -- 8,250 US agency mortgage-backed securities 2,161 5,434 2,908 10,810 DRD agency preferred stock -- 6,020 -- -- Equity securities 3,316 -- 2,965 -- Other securities 999 6,902 999 4,772 ----------------------------------------------------------------------------------------------------------------------- Total $42,328 $86,088 $40,683 $62,988 =======================================================================================================================
-------------------------------------------------------------------------------- DNB's investment portfolio (HTM and AFS securities) totaled $128.4 million at December 31, 2000, up 24% from $103.7 million at December 31, 1999. The growth in the investment portfolio was funded by increased deposits and borrowings during the year. DNB had investment securities which represented a significant concentration (greater than 10% of stockholders' equity) as follows: 2000 --------------------------------------- # of Amortized Estimated (Dollars in thousands) Securities Cost Fair Value ----------------------------------------------------------------- Private label CMOs 2 $5,500 $5,466 ----------------------------------------------------------------- 1999 --------------------------------------- # of Amortized Estimated (Dollars in thousands) Securities Cost Fair Value ----------------------------------------------------------------- Private label CMOs 2 $5,517 $5,485 ----------------------------------------------------------------- Corporate bond 1 2,950 2,753 ----------------------------------------------------------------- The table on the previous page and the table above set forth information regarding the composition, stated maturity and average yield of DNB's investment security portfolio as of the dates indicated. The first table does not include amortization or anticipated prepayments on mortgage-backed securities. Callable securities are included at their stated maturity dates. Loans The loan portfolio consists primarily of commercial and residential real estate loans, commercial loans and lines of credit (including commercial construction), and consumer loans. The loan portfolio provides a stable source of interest income, monthly amortization of principal and, in the case of adjustable rate loans, repricing opportunities. Net loans were $186.3 million at December 31, 2000, up $19.9 million or 12% from 1999. Commercial mortgage loans increased $9.6 million or 17% to $67.3 million, consumer loans increased $4.5 million or 13% to $39.7 million, and residential loans increased $3.3 million or 8% to $43.2 million. The increase in these portfolios continues to reflect DNB's commitment to commercial and residential development in Chester County and northern Delaware. The table on the next page sets forth information concerning the composition of total loans outstanding, net of the allowance for loan losses, as of the dates indicated. Non-Performing Assets Total non-performing assets decreased slightly during 2000, and at December 31, 2000 were $2.0 million compared to $2.1 million at December 31, 1999 and $3.3 million at December 31, 1998. During 1999, nonaccrual loans decreased $1.1 million, while loans 90 days past due and still accruing remained relatively the same and included two loans to a single borrower that are well secured and have demonstrated a sus- 10 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- tained period of repayment performance. DNB, which has a significant level of commercial, real estate and consumer loans, has worked diligently to improve asset quality and position itself for possible economic downturns in the future by tightening underwriting standards and improving lending policies and procedures. Non-performing assets have, and will continue to have, an impact on earnings, therefore management intends to continue working aggressively to reduce the level of such assets. Non-performing assets are comprised of nonaccrual loans, loans delinquent over ninety days and still accruing, troubled debt restructurings ("TDRs") and other real estate owned ("OREO"). Nonaccrual loans are loans on which the accrual of interest ceases when the collection of principal or interest payments is determined to be doubtful by management. It is the policy of DNB to discontinue the accrual of interest when principal or interest payments are delinquent 90 days or more (unless the loan principal and interest are determined by management to be fully secured and in the process of collection), or earlier, if considered prudent. Interest received on such loans is applied to the principal balance, or may in some instances be recognized as income on a cash basis. OREO includes both real estate obtained as a result of, or in lieu of, foreclosure. Any significant change in the level of non-performing assets is dependent, to a large extent, on the economic climate within DNB's market area. -------------------------------------------------------------------------------- Total Loans Outstanding, Net of Allowance for Loan Losses
(Dollars in thousands) December 31 --------------------------------------------------------------------- 2000 1999 1998 1997 1996 ======================================================================================================================= Residential mortgage $ 43,227 $ 39,873 $ 29,656 $ 20,392 $ 17,658 Commercial mortgage 67,302 57,656 51,434 46,130 45,907 Commercial 41,000 38,734 35,549 34,966 29,970 Consumer 39,672 35,193 32,087 28,466 28,037 ----------------------------------------------------------------------------------------------------------------------- Total loans, net of unearned income 191,201 171,456 148,726 129,954 121,572 Less allowance for loan losses (4,917) (5,085) (5,205) (5,281) (5,112) ----------------------------------------------------------------------------------------------------------------------- Net loans $186,284 $166,371 $143,521 $124,673 $116,460 =======================================================================================================================
The following table sets forth information concerning the contractual maturities of the loan portfolio, net of unearned income and fees. For amortizing loans, scheduled repayments for the maturity category in which the payment is due are not reflected below, because such information is not readily available.
Loan Maturities December 31, 2000 ----------------------------------------------------------------------- (Dollars in thousands) Less than 1 Year 1-5 Years Over 5 Years Total ======================================================================================================================= Real estate $12,310 $38,602 $59,617 $110,529 Commercial 39,512 1,477 11 41,000 Consumer 3,912 11,353 24,407 39,672 ----------------------------------------------------------------------------------------------------------------------- Total loans, net of unearned income 55,734 51,432 84,035 191,201 ======================================================================================================================= Loans with predetermined interest rates 14,815 22,086 81,731 118,632 Loans with variable interest rates 40,919 29,346 2,304 72,569 ----------------------------------------------------------------------------------------------------------------------- Total loans, net of unearned income $55,734 $51,432 $84,035 $191,201 =======================================================================================================================
Downingtown National Bank [LOGO] 11 Management's Discussion and Analysis -------------------------------------------------------------------------------- The table at the bottom of this page sets forth those assets that are: (i) placed on nonaccrual status, (ii) contractually delinquent by 90 days or more and still accruing, (iii) troubled debt restructurings other than those included in items (i) and (ii), and (iv) OREO as a result of foreclosure or voluntary transfer to DNB. DNB's Special Assets Committee monitors the performance of the loan portfolio to identify potential problem assets on a timely basis. Committee members meet to design, implement and review asset recovery strategies which serve to maximize the recovery of each troubled asset. DNB had $8.0 million of loans which, although performing at December 31, 2000, are believed to require increased supervision and review; and may, depending on the economic environment and other factors, become non-performing assets in future periods. The amount of such loans at December 31, 1999 was $7.9 million. The majority of the loans are secured by commercial real estate, with lesser amounts being secured by residential real estate, inventory and receivables. Allowance for Loan Losses The allowance for loan losses is increased by the provision for loan losses which is charged to operations. Loan losses are charged directly against the allowance and recoveries on previously charged-off loans are added to the allowance. In establishing its allowance for loan losses, management considers the size and risk exposure of each segment of the loan portfolio, past loss experience, present indicators of risk such as delinquency rates, levels of nonaccruals, and other relevant factors. Management's evaluation of the loan portfolio generally includes reviews, on a sample basis, of individual borrowers of $350,000 or greater and reviews of problem borrowers of $100,000 or greater. Consideration is also given to examinations performed by regulatory agencies, primarily the Office of the Comptroller of the Currency ("OCC"). The table on the following page sets forth the changes in DNB's allowance for loan losses for --------------------------------------------------------------------------------
Non-Performing Assets December 31 ----------------------------------------------------------------------- (Dollars in thousands) 2000 1999 1998 1997 1996 ======================================================================================================================= Nonaccrual loans: Residential mortgage $ 137 $-- $ 250 $ 676 $ 743 Commercial mortgage 157 361 1,063 1,301 1,315 Commercial 573 674 990 821 650 Consumer 317 292 114 107 187 ----------------------------------------------------------------------------------------------------------------------- Total nonaccrual loans 1,184 1,327 2,417 2,905 2,895 Loans 90 days past due and still accruing 609 694 699 70 194 Troubled debt restructurings 40 -- -- -- 184 ----------------------------------------------------------------------------------------------------------------------- Total non-performing loans 1,833 2,021 3,116 2,975 3,273 Other real estate owned 183 83 139 231 1,010 ----------------------------------------------------------------------------------------------------------------------- Total non-performing assets $2,016 $2,104 $3,255 $3,206 $4,283 ======================================================================================================================= Asset quality ratios: Non-performing loans to total loans 0.96% 1.17% 2.10% 2.29% 2.69% Non-performing assets to total assets 0.57 0.69 1.23 1.46 2.07 Allowance for loan losses to: Total loans 2.56 2.96 3.50 4.06 4.20 Non-performing loans 268.10 251.61 167.04 177.51 156.17 Non-performing assets 243.90 241.68 159.91 164.72 119.36 =======================================================================================================================
12 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- the years indicated. Real estate includes both residential and commercial real estate. In determining the adequacy of the allowance, DNB utilizes a methodology which includes an analysis of historical loss experience for the commercial real estate, commercial, residential real estate, home equity and consumer installment loan pools to determine a historical loss factor. The historical loss factors are then applied to the current portfolio balances to determine the required reserve percentage for each loan pool based on risk rating. In addition, specific alloca-tions are established for loans where loss is probable and reasonably identifiable, based on management's judgment and an evaluation of the individual credit, which includes various factors mentioned above. The allocated portion of the reserve is then determined as a result of an analysis of the loan pools and specific allocations. The table at the bottom of this page sets forth the composition of DNB's allowance for loan losses at the dates indicated. The portion allocated --------------------------------------------------------------------------------
Analysis of Allowance for Loan Losses (Dollars in thousands) Year Ended December 31 ---------------------------------------------------------------------- 2000 1999 1998 1997 1996 ======================================================================================================= Beginning balance $5,085 $5,205 $5,281 $5,112 $5,515 Provisions -- -- -- -- -- Loans charged off: Real estate (138) (171) (59) -- (454) Commercial (65) (35) (233) (32) (50) Consumer (21) (10) (11) (16) (30) ------------------------------------------------------------------------------------------------------- Total charged off (224) (216) (303) (48) (534) ------------------------------------------------------------------------------------------------------- Recoveries: Real estate 13 21 144 1 38 Commercial 33 68 71 167 48 Consumer 10 7 12 49 45 ------------------------------------------------------------------------------------------------------- Total recoveries 56 96 227 217 131 ------------------------------------------------------------------------------------------------------- Ending balance $4,917 $5,085 $5,205 $5,281 $5,112 =======================================================================================================
Composition of Allowance for Loan Losses (Dollars in thousands) December 31 2000 1999 1998 1997 1996 Percent of Percent of Percent of Percent of Percent of Loan Type to Loan Type to Loan Type to Loan Type to Loan Type to Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans ------------------------------------------------------------------------------------------------------------------------ Real estate $1,449 58% $1,272 57% $1,537 54% $1,104 51% $1,405 52% Commercial* 1,555 21 1,275 23 1,192 24 1,220 27 830 25 Consumer 270 21 199 20 185 22 164 22 231 23 Unallocated 1,643 -- 2,339 -- 2,291 -- 2,793 -- 2,646 -- ----------------------------------------------------------------------------------------------------------------------- Total $4,917 100% $5,085 100% $5,205 100% $5,281 100% $5,112 100% -----------------------------------------------------------------------------------------------------------------------
*includes commercial construction Downingtown National Bank [LOGO] 13 Management's Discussion and Analysis -------------------------------------------------------------------------------- to each category is generally not the total amount available for future losses that might occur within such categories. The allocation of the allowance should also not be interpreted as an indication that charge-offs will occur in these amounts or proportions. The specific allocations in any particular category may prove excessive or inadequate and consequently may be reallocated in the future to reflect current conditions. Accordingly, management considers the entire allowance to be available to absorb losses in any category. The $696,000 reduction in the unallocated reserve during 2000 can be attributed to the increased concentration in the commercial and commercial mortgage loan categories. Management has also increased the effect given to several of the qualitative risk factors in determining the adequacy of the allowance in light of a slowing economy. Liquidity and Capital Resources Management maintains liquidity to meet depositors' needs for funds, to satisfy or fund loan commitments, and for other operating purposes. DNB's foundation for liquidity is a stable and loyal customer deposit base and a marketable investment portfolio that provides periodic cash flow through regular maturities and amortization, or that can be used as collateral to secure funding. DNB's primary source of liquidity is dependent upon its ability to maintain and expand its customer deposit base. During 2000, deposits increased $35.9 million or 14%. As of December 31, 2000, deposits totaled $290.8 million, up from $254.9 million at December 31, 1999. Certificates of deposit increased $12.1 million to $101.8 million and money market accounts increased $11.7 million to $59.2 million. Both money market and certificate categories increased as a result of successful promotions. In addition, IRA accounts and NOW accounts increased a combined $5.4 million. Non-interest bearing deposits increased $7.0 million to $38.9 million, primarily due to a year-end build up of deposits by several business accounts. DNB maintains borrowing arrangements with a correspondent bank and the Federal Home Loan Bank of Pittsburgh, as well as access to the discount window at the Federal Reserve Bank of Philadelphia, to meet short-term liquidity needs. Through these relationships, DNB has additional short-term credit available of approximately $74.4 million. At December 31, 2000, DNB had $17.1 million in commitments to fund commercial real estate, construction and land development loans. In addition, there were $4.1 million in unfunded home equity lines of credit and $7.4 million in other unused loan commitments. Management The following table sets forth the composition of DNB's deposits at the dates indicated. --------------------------------------------------------------------------------
Deposits By Major Classification (Dollars in thousands) December 31 --------------------------------------------------------------------- 2000 1999 1998 1997 1996 ====================================================================================================== Non-interest-bearing deposits $ 38,898 $ 31,864 $ 30,001 $ 27,150 $ 26,429 Interest-bearing deposits: NOW 44,450 39,501 37,075 33,387 31,140 Money market 59,250 47,517 32,582 19,289 15,550 Savings 29,811 30,199 28,321 27,714 28,559 Certificates 101,794 89,691 82,424 78,509 63,783 IRA 16,588 16,109 14,970 13,188 12,963 ------------------------------------------------------------------------------------------------------ Total deposits $290,791 $254,881 $225,373 $199,237 $178,424 ======================================================================================================
14 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- anticipates the majority of these commitments will be funded by means of normal cash flows. There are approximately $83.4 million in certificates of deposit scheduled to mature during the twelve months ending December 31, 2001. To meet its funding needs, DNB maintains assets which comprise its primary liquidity totaling $114.3 million on December 31, 2000. Primary liquidity includes Federal funds sold, investments and interest-bearing cash balances, less pledged securities. DNB also anticipates scheduled payments and prepayments on its loan and mortgage-backed securities portfolios. Interest Rate Sensitivity Analysis The largest component of DNB's total income is net interest income, and the majority of DNB's financial instruments are composed of interest rate-sensitive assets and liabilities with various terms and maturities. The primary objective of management is to maximize net interest income while minimizing interest rate risk. Inter- --------------------------------------------------------------------------------
Interest Rate Sensitivity Analysis (Dollars in thousands) December 31, 2000 -------------------------------------------------------------------------------------------- More Than More Than More Than More Than More Than One Year Two Years Three Years Four Years Five Years Under One Through Through Through Through and Year Two Years Three Years Four Years Five Years Non-repricing Total ----------------------------------------------------------------------------------------------------------------------------- ASSETS Cash and due from banks and Federal funds sold $ 16,683 $-- $-- $-- $-- $ 10,669 $ 27,352 Investments 59,183 17,479 18,723 4,281 4,263 24,487 128,416 Commercial loans 30,724 3,284 2,859 1,725 632 1,776 41,000 Mortgage loans 18,998 10,704 16,532 8,835 12,485 42,975 110,529 Consumer loans 9,468 4,958 4,698 3,982 3,182 13,384 39,672 Other assets -- -- -- -- -- 9,701 9,701 ============================================================================================================================= Total assets $135,056 $ 36,425 $ 42,812 $18,823 $ 20,562 $102,992 $356,670 ============================================================================================================================= LIABILITIES AND EQUITY Non-interest-bearing demand $ -- $ -- $ -- $ 6,483 $ 6,484 $ 25,931 $ 38,898 NOW 18,909 3,649 7,297 3,649 3,649 7,297 44,450 Money market 53,690 2,780 2,780 -- -- -- 59,250 Savings 8,646 3,279 5,962 2,981 2,981 5,962 29,811 Certificates and IRAs less than $100,000 58,354 17,899 11,720 390 178 81 88,622 Certificates and IRAs at or more than $100,000 25,062 3,119 1,353 -- 149 77 29,760 ----------------------------------------------------------------------------------------------------------------------------- Total deposits 164,661 30,726 29,112 13,503 13,441 39,348 290,791 Borrowings -- 3,000 -- -- 17,000 20,741 40,741 Other liabilities -- -- -- -- -- 1,908 1,908 Stockholders' equity -- -- -- -- -- 23,230 23,230 ----------------------------------------------------------------------------------------------------------------------------- Total liabilities and equity $164,661 $ 33,726 $ 29,112 $13,503 $ 30,441 $ 85,227 $356,670 ============================================================================================================================= Gap (29,605) $ 2,699 $ 13,700 $ 5,320 $ (9,879) $ 17,765 ============================================================================================================================= Cumulative gap $ (29,605) $ (26,906) $ (13,206) $ (7,886) $ (17,765) $-- ============================================================================================================================= Cumulative gap to total assets (8.3%) (7.5%) (3.7%) (2.2%) (5.0%) ============================================================================================================================= Downingtown National Bank [LOGO] 15
Management's Discussion and Analysis -------------------------------------------------------------------------------- est rate risk is derived from timing differences in the repricing of assets and liabilities, loan prepayments, deposit withdrawals, and differences in lending and funding rates. The Asset-Liability Committee ("ALCO") actively seeks to monitor and control the mix of interest rate-sensitive assets and interest rate-sensitive liabilities. One measure of interest rate risk is the gap ratio, which is defined as the difference between the dollar volume of interest-earning assets and interest-bearing liabilities maturing or repricing within a specified period of time as a percentage of total assets. A positive gap results when the volume of interest rate-sensitive assets exceeds that of interest rate-sensitive liabilities within comparable time periods. A negative gap results when the volume of interest rate-sensitive liabilities exceeds that of interest rate-sensitive assets within comparable time periods. As indicated in the table on the previous page, the one year gap position at December 31, 2000 was a negative 8.3%. This was reduced from a negative gap of 14.3% at December 31, 1999. Generally, a financial institution with a negative gap position will most likely experience decreases in net interest income during periods of rising rates and increases in net interest income during periods of falling interest rates. The negative gap was due largely to customer preferences for short-term and floating rate deposit products and fixed rate loans which caused interest-rate sensitive liabilities to exceed interest- rate sensitive assets during the earlier time periods presented. While gap analysis represents a useful asset/liability management tool, it does not necessarily indicate the affect of general interest rate movements on DNB's net interest income, due to discretionary repricing of assets and liabilities, and other competitive pressures. DNB reports its callable agency, callable corporate notes and callable municipal investments ($57.9 million at December 31, 2000) at their Option Adjusted Spread ("OAS") modified duration date, as opposed to the call or maturity date. In management's opinion, using modified duration dates on callable securities provides a better estimate of the option exercise date under any interest rate environment. The OAS methodology is an approach whereby the likelihood of an option exercise takes into account the coupon on the security, the distance to the call date, the maturity date and current interest rate volatility. In addition, prepayment assumptions derived from historical data have been applied to mortgage-related securities, which are included in investments. Included in the analysis of the gap position are certain savings and demand accounts which are less sensitive to fluctuations in interest rates than other interest-bearing sources of funds. In determining the sensitivity of such deposits, management reviews the movement of its deposit rates for the past five years relative to market rates. Using regression analysis, the ALCO has estimated that these deposits are approximately 25-30% sensitive to interest rate changes (i.e., if short term rates were to increase 100 basis points, the interest rate on such deposits would increase 25-30 basis points). The table on the previous page sets forth certain information relating to DNB's financial instruments that are sensitive to changes in interest rates, categorized by expected maturity or repricing at December 31, 2000. The Bank continually evaluates interest rate risk management opportunities, including the use of derivative financial instruments. Management believes that hedging instruments currently available are not cost-effective, and therefore, has focused its efforts on increasing DNB's spread by attracting lower-costing retail deposits. In addition to utilizing the gap ratio for interest rate risk management, the ALCO utilizes simulation analysis whereby the model estimates the variance in net interest income with a change in interest rates of plus or minus 300 basis points over a twelve and twenty-four month period. Given recent simulations, net interest income would be within policy guidelines regardless of the direction of market rates. Market Risk Analysis To measure the impacts of longer-term asset and liability mismatches beyond two years, DNB 16 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- utilizes Modified Duration of Equity and Economic Value of Portfolio Equity ("EVPE") models. The modified duration of equity measures the potential price risk of equity to changes in interest rates. A longer modified duration of equity indicates a greater degree of risk to rising interest rates. Because of balance sheet optionality, an EVPE analysis is also used to dynamically model the present value of asset and liability cash flows, with rates ranging up or down 200 basis points. The economic value of equity is likely to be different as interest rates change. Results falling outside prescribed ranges require action by the ALCO. At December 31, 2000 and 1999, DNB's variance in the economic value of equity as a percentage of assets with an instantaneous and sustained parallel shift of 200 basis points is within the Bank's negative 3% policy guideline, as shown in the tables below. The market capitalization of DNB should not be equated to the EVPE, which only deals with the valuation of balance sheet cash flows using conservative assumptions. Calculated core deposit premiums may be less than what is available in an outright sale. The model does not consider potential premiums on floating rate loan sales, the impact of overhead expense, non-interest income, taxes, industry market price multiples and other factors reflected in the market capitalization of a company. Market Risk Analysis (Dollars in thousands) December 31, 2000 --------------------------------- Change in Rates Flat -200 bp +200 bp ========================================================== EVPE $28,870 $27,205 $23,082 Change (1,665) (5,788) Change as a % of assets (0.47%) (1.62%) ========================================================== December 31, 1999 --------------------------------- Change in Rates Flat -200 bp +200 bp ========================================================== EVPE $28,232 $33,060 $20,351 Change 4,828 (7,881) Change as a % of assets 1.60% (2.62%) ========================================================== Capital Resources Stockholders' equity increased to $23.2 million at December 31, 2000. Net income of $2.7 million reported for the year was complemented by the net unrealized gain in the available-for-sale investment portfolio ($806,000) and offset by dividends paid ($838,000). Management believes that the Corporation and the Bank have each met the definition of "well capitalized" for regulatory purposes on December 31, 2000. The Bank's capital category is determined for the purposes of applying the bank regulators' "prompt corrective action" regulations and for determining levels of deposit insurance assessments and may not constitute an accurate representation of the Corporation's or the Bank's overall financial condition or prospects. The Corporation's capital exceeds the FRB's minimum leverage ratio requirements for bank holding companies (see additional discussion in Regulatory Matters -- Footnote 16). Regulatory Matters Dividends payable to the Corporation by the Bank are subject to certain regulatory limitations. Under normal circumstances, the payment of dividends in any year without regulatory permission is limited to the net profits (as defined for regulatory purposes) for that year, plus the retained net profits for the preceding two calendar years, which amounted to $6.1 million for the year ended December 31, 2000. Forward-Looking Statements Certain statements in this report, including any which are not statements of historical fact, may constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Without limiting the foregoing, the words "expect", "anticipate", "plan", "believe", "seek", "estimate", "predict", "internal" and similar words are intended to identify expressions that may be forward-looking statements. Forward-looking statements involve certain risks and uncertainties, and actual results may differ materially from those contemplated by such statements. For example, Downingtown National Bank [LOGO] 17 Management's Discussion and Analysis -------------------------------------------------------------------------------- actual results may be adversely affected by the following possibilities: (1) competitive pressures among financial institutions may increase; (2) changes in interest rates may reduce banking interest margins; (3) general economic conditions and real estate values may be less favorable than contemplated; (4) adverse legislation or regulatory requirements may be adopted; (5) other unexpected contingencies may arise. Many of these factors are beyond DNB's ability to control or predict. Readers of this report are accordingly cautioned not to place undue reliance on forward-looking statements. DNB disclaims any intent or obligation to update publicly any of the forward-looking statements herein, whether in response to new information, future events or otherwise. Recent Accounting Pronouncements In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which was subsequently amended ("SFAS No. 133"). This statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and those used for hedging activities, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. SFAS No. 133 generally provides for matching of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk, so long as the hedge is effective. Prospective application of SFAS No. 133 is required for all fiscal years beginning after June 15, 2000, however earlier application is permitted. SFAS No. 133 was adopted on January 1, 2001 and there was no impact on operations, financial condition and equity and comprehensive income. DNB currently has no derivatives covered by this statement and currently conducts no hedging activities. Market for Common Stock DNB Financial Corporation's common stock is listed under the symbol "DNBF" on the Over The Counter Electronic Bulletin Board, an automated quotation service, made available through and governed by the NASDAQ system. Current price information is available from account executives at most brokerage firms as well as the firms listed at the back of this annual report who are market makers of DNB's common stock. There were approximately 900 stockholders who owned 1.7 million shares of common stock outstanding at December 31, 2000. The following table sets forth the quarterly high and low prices for a share of DNB's common stock during the periods indicated. Prices for the sale of stock are based upon transactions reported by the brokerage firms of Tucker Anthony Cleary Gull, Inc. and Ryan, Beck & Company. The quoted high and low bids prices are limited only to those transactions known by management to have occurred and there may, in fact, have been additional transactions of which management is unaware. Prices have been adjusted for stock dividends. 2000 1999 ------------------------------------------ High Low High Low =========================================================== First quarter $15.95 $12.38 $28.57 $26.30 Second quarter 14.29 12.62 26.98 24.49 Third quarter 15.48 12.98 25.40 22.10 Fourth quarter 15.36 14.00 22.22 15.95 =========================================================== The table on the following page sets forth selected quarterly financial data and earnings per share for the periods indicated. Per share data have been adjusted for the five percent (5%) stock dividends declared in 2000 and 1999. 18 Downingtown National Bank [LOGO] Management's Discussion and Analysis -------------------------------------------------------------------------------- Quarterly Financial Data (Dollars in thousands, except per share data)
2000 1999 ---------------------------------------------------------------------------------------- Fourth Third Second First Fourth Third Second First Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter ======================================================================================================================= Interest income $6,433 $6,166 $5,698 $5,455 $5,441 $5,232 $5,130 $4,697 Interest expense 3,675 3,429 2,965 2,721 2,740 2,516 2,350 2,219 ----------------------------------------------------------------------------------------------------------------------- Net interest income 2,758 2,737 2,733 2,734 2,701 2,716 2,780 2,478 Provision for loan losses -- -- -- -- -- -- -- -- Non-interest income 490 438 419 393 382 495 391 366 Non-interest expense 2,265 2,284 2,232 2,150 2,035 2,198 2,072 1,926 ----------------------------------------------------------------------------------------------------------------------- Income before income taxes 983 891 920 977 1,048 1,013 1,099 918 Income tax expense 219 266 285 293 280 323 352 291 ----------------------------------------------------------------------------------------------------------------------- Net income $ 764 $ 625 $ 635 $ 684 $ 768 $ 690 $ 747 $ 627 ----------------------------------------------------------------------------------------------------------------------- Basic earnings per share $ 0.45 $ 0.37 $ 0.38 $ 0.40 $ 0.46 $ 0.41 $ 0.44 $ 0.37 Diluted earnings per share 0.45 0.36 0.37 0.40 0.44 0.40 0.43 0.36 ----------------------------------------------------------------------------------------------------------------------- Cash dividends per share $0.125 $0.125 $0.125 $0.125 $0.117 $0.117 $0.118 $0.118 ======================================================================================================================= Downingtown National Bank [LOGO] 19
DNB FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Financial Condition
December 31 --------------------------------------- 2000 1999 =================================================================================================== Assets Cash and due from banks $ 13,002 $ 11,226 Federal funds sold 14,350 6,304 --------------------------------------------------------------------------------------------------- Cash and cash equivalents 27,352 17,530 --------------------------------------------------------------------------------------------------- Investment securities available for sale, at market value 86,088 62,988 Investment securities (market value $42,358 in 2000 and $39,869 in 1999) 42,328 40,683 Loans, net of unearned income 191,201 171,456 Allowance for loan losses (4,917) (5,085) --------------------------------------------------------------------------------------------------- Net loans 186,284 166,371 --------------------------------------------------------------------------------------------------- Office property and equipment 5,889 5,776 Accrued interest receivable 2,580 1,804 Other real estate owned 183 83 Deferred income taxes 1,427 2,002 Other assets 4,539 4,112 --------------------------------------------------------------------------------------------------- Total assets $356,670 $301,349 =================================================================================================== Liabilities and Stockholders' Equity Liabilities Non-interest-bearing deposits $ 38,898 $ 31,864 Interest-bearing deposits: NOW 44,450 39,501 Money market 59,250 47,517 Savings 29,811 30,199 Time 118,382 105,800 --------------------------------------------------------------------------------------------------- Total deposits 290,791 254,881 --------------------------------------------------------------------------------------------------- FHLB advances and other borrowings 40,741 23,746 Accrued interest payable 1,450 1,078 Other liabilities 458 1,106 --------------------------------------------------------------------------------------------------- Total liabilities 333,440 280,811 =================================================================================================== Commitments and contingencies Stockholders' Equity Preferred stock, $10.00 par value; 1,000,000 shares authorized; none issued -- -- Common stock, $1.00 par value; 10,000,000 shares authorized; 1,691,575 and 1,609,463 issued and outstanding, respectively 1,692 1,609 Surplus 19,676 18,555 Retained earnings 3,111 2,429 Accumulated other comprehensive loss (1,249) (2,055) --------------------------------------------------------------------------------------------------- Total stockholders' equity 23,230 20,538 --------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $356,670 $301,349 ===================================================================================================
See accompanying notes to consolidated financial statements. 20 Downingtown National Bank [LOGO] DNB FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Operations
Year Ended December 31 -------------------------------------------------- 2000 1999 1998 ============================================================================================================= Interest Income: Interest and fees on loans $15,057 $13,825 $12,092 Interest and dividends on investment securities: Taxable 7,735 5,846 4,898 Exempt from Federal taxes 512 445 56 Interest on Federal funds sold 448 384 857 ------------------------------------------------------------------------------------------------------------- Total interest income 23,752 20,500 17,903 ------------------------------------------------------------------------------------------------------------- Interest Expense: Interest on NOW, money market and savings 4,239 3,357 2,519 Interest on time deposits 6,751 5,378 5,276 Interest on FHLB advances 1,690 1,014 470 Interest on other borrowings 110 76 1 ------------------------------------------------------------------------------------------------------------- Total interest expense 12,790 9,825 8,266 ------------------------------------------------------------------------------------------------------------- Net interest income 10,962 10,675 9,637 Provision for loan losses -- -- -- ------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 10,962 10,675 9,637 ------------------------------------------------------------------------------------------------------------- Non-interest Income: Service charges 755 627 515 Trust 448 399 430 Gains on sales of investment securities 15 -- 5 Other 522 608 556 ------------------------------------------------------------------------------------------------------------- Total non-interest income 1,740 1,634 1,506 ------------------------------------------------------------------------------------------------------------- Non-interest Expense: Salaries and employee benefits 4,732 4,254 3,911 Furniture and equipment 1,029 927 711 Occupancy 622 519 438 Professional and consulting 533 492 347 Marketing 315 422 278 Printing and supplies 278 283 168 Other 1,422 1,334 1,116 ------------------------------------------------------------------------------------------------------------- Total non-interest expense 8,931 8,231 6,969 ------------------------------------------------------------------------------------------------------------- Income before income taxes 3,771 4,078 4,174 Income tax expense 1,063 1,246 1,252 ------------------------------------------------------------------------------------------------------------- Net Income $ 2,708 $ 2,832 $ 2,922 ============================================================================================================= Earnings per share: Basic $1.60 $1.68 $1.74 Diluted 1.58 1.63 1.67 Cash dividends per share $0.50 $0.47 $0.41 Weighted average common shares outstanding: Basic 1,691,477 1,683,863 1,680,745 Diluted 1,714,062 1,740,615 1,754,465 ============================================================================================================= See accompanying notes to consolidated financial statements.
Downingtown National Bank [LOGO] 21 DNB FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Stockholders' Equity and Comprehensive Income
Accumulated Other Comprehensive Common Retained Comprehensive Income Stock Surplus Earnings Income (Loss) Total ----------------------------------------------------------------------------------------------------------------------- Balance at January 1, 1998 $1,449 $14,610 $ 2,276 $ 21 $18,356 Comprehensive Income: Net income $ 2,922 -- -- 2,922 -- 2,922 Other comprehensive income, net of tax, relating to net unrealized gains on investments 32 -- -- -- 32 32 ------- Total comprehensive income 2,954 Cash dividends -- -- (697) -- (697) Issuance of stock dividends 72 2,222 (2,294) -- -- Cash payment for fractional shares -- -- (10) -- (10) Exercise of stock options 3 7 (7) -- 3 Transfer to surplus -- 266 (266) -- -- ----------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1998 1,524 17,105 1,924 53 20,606 Comprehensive Income: Net income 2,832 -- -- 2,832 -- 2,832 Other comprehensive income, net of tax, relating to net unrealized losses on investments (2,108) -- -- -- (2,108) (2,108) ------- Total comprehensive income 724 Cash dividends -- -- (795) -- (795) Issuance of stock dividends 76 1,450 (1,526) -- -- Cash payment for fractional shares -- -- (6) -- (6) Exercise of stock options 9 -- -- -- 9 ----------------------------------------------------------------------------------------------------------------------- Balance at December 31, 1999 1,609 18,555 2,429 (2,055) 20,538 Comprehensive Income: Net income 2,708 -- -- 2,708 -- 2,708 Other comprehensive income, net of tax, relating to net unrealized losses on investments 806 -- -- -- 806 806 ------- Total comprehensive income 3,514 Cash dividends -- -- (838) -- (838) Issuance of stock dividends 80 1,103 (1,183) -- -- Cash payment for fractional shares -- -- (5) -- (5) Exercise of stock options 3 18 -- -- 21 ----------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2000 $1,692 $19,676 $ 3,111 $(1,249) $23,230 =======================================================================================================================
See accompanying notes to consolidated financial statements. 22 Downingtown National Bank [LOGO] DNB FINANCIAL CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows
Year Ended December 31 -------------------------------------------------- 2000 1999 1998 ======================================================================================================================= Cash Flows From Operating Activities: Net income $ 2,708 $ 2,832 $ 2,922 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and accretion 702 821 750 Gains on sale of OREO -- (159) (162) Net gain on sale of securities (15) -- (5) Increase in interest receivable (776) (134) (86) Increase in other assets (427) (2,350) (396) Increase in interest payable 372 176 71 Increase (decrease) in current taxes payable 13 (137) (89) Decrease (increase) in deferred income taxes 198 26 (75) (Decrease) increase in other liabilities (663) 706 (401) ======================================================================================================================= Net Cash Provided By Operating Activities 2,112 1,781 2,529 ----------------------------------------------------------------------------------------------------------------------- Cash Flows From Investing Activities: Proceeds from maturities and paydowns - AFS securities 4,175 1,554 6,353 Proceeds from maturities and paydowns - HTM securities 8,418 13,180 38,450 Proceeds from maturities & paydowns-MBS-AFS 3,779 2,550 2,248 Proceeds from maturities & paydowns-MBS-HTM 743 1,965 1,727 Purchase of AFS securities (42,273) (17,887) (42,388) Purchase of HTM securities (10,869) (5,567) (20,514) Purchase of MBS-AFS -- (6,838) -- Purchase of MBS-HTM -- (3,011) (17,475) Proceeds from sale of securities-AFS 12,466 -- 1,996 Proceeds from sale of OREO -- 683 542 Net increase in loans (20,012) (23,319) (19,135) Purchase of bank property and equipment (800) (1,854) (1,326) ----------------------------------------------------------------------------------------------------------------------- Net Cash Used By Investing Activities (44,373) (38,544) (49,522) ----------------------------------------------------------------------------------------------------------------------- Cash Flows From Financing Activities: Net increase in deposits 35,910 29,508 26,136 Increase in FHLB advances greater than ninety days 17,000 5,000 18,000 (Decrease) increase in lease obligations (5) 746 -- Dividends paid (838) (801) (707) Proceeds from issuance of stock under stock option plan 16 9 3 ----------------------------------------------------------------------------------------------------------------------- Net Cash Provided By Financing Activities 52,083 34,462 43,432 ----------------------------------------------------------------------------------------------------------------------- Net Change in Cash and Cash Equivalents 9,822 (2,301) (3,561) Cash and Cash Equivalents at Beginning of Period 17,530 19,831 23,392 ----------------------------------------------------------------------------------------------------------------------- Cash and Cash Equivalents at End of Period $27,352 $17,530 $19,831 ======================================================================================================================= Supplemental Disclosure Of Cash Flow Information: Cash paid during the period for: Interest $12,418 $ 9,649 $ 8,195 Income taxes 825 1,357 1,417 Supplemental Disclosure Of Non-cash Flow Information: Net transfer of loans to OREO $ 99 $ 469 $ 332 Change in unrealized gains (losses) on securities - AFS 1,184 (3,098) 48 Change in deferred taxes due to change in unrealized gains or losses on securities - AFS (378) 990 (16) =======================================================================================================================
See accompanying notes to consolidated financial statements. Downingtown National Bank [LOGO] 23 Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES DNB Financial Corporation (the "Corporation" or "DNB") through its wholly owned subsidiary, Downingtown National Bank (the "Bank"), has been serving individuals and small to medium sized businesses of Chester County, Pennsylvania since 1861. The Bank is a locally managed commercial bank providing personal and commercial loans and deposit products, in addition to investment and trust services from eight community offices. The Bank encounters vigorous competition for market share from commercial banks, thrift institutions, credit unions and other financial intermediaries. The consolidated financial statements of DNB and its subsidiary, the Bank, which together are managed as a single segment entity, are prepared in accordance with accounting principles generally accepted in the United States of America, as applicable to the banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and affect revenues and expenses for the period. Actual results could differ significantly from those estimates. The material estimates that are particularly susceptible to significant changes in the near term relate to the determination of the adequacy of the allowance for loan losses and the valuation of other real estate owned. In connection with the determination of the allowance for losses on loans and other real estate owned, independent appraisals for significant properties are obtained when practical. The more significant accounting policies are summarized below. Prior period amounts not affecting net income are reclassified when necessary to conform with current year classifications. Principles of Consolidation -- The accompanying consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiary, the Bank. All significant intercompany transactions have been eliminated. Cash and Due From Banks -- DNB is required to maintain certain daily reserve balances in accordance with Federal Reserve Board requirements. The average reserve balance maintained in accordance with such requirements for the years ended December 31, 2000 and 1999 was approximately $1.7 million and $1.2 million, respectively. Investment Securities -- Investment securities are classified and accounted for as follows: Held-To-Maturity ("HTM") -- includes debt and non-readily marketable equity securities that DNB has the positive intent and ability to hold to maturity. Debt securities are reported at cost, adjusted for amortization of premiums and accretion of discounts. Non-readily marketable equity securities are carried at cost, which approximates liquidation value. Trading Account ("TA") -- includes securities which are generally held for a short term in anticipation of market gains. Such securities would be carried at fair value with realized and unrealized gains and losses on trading account securities included in the statement of operations. DNB did not have any securities classified as TA during 2000, 1999, or 1998. Available-For-Sale ("AFS") -- includes debt and equity securities not classified as HTM or TA securities. Securities classified as AFS are securities that DNB intends to hold for an indefinite period of time, but not necessarily to maturity. Such securities are reported at fair value, with unrealized holding gains and losses excluded from earnings and reported, net of tax (if applicable), as a separate component of stockholders' equity. Realized gains and losses on the sale of AFS securities are computed on the basis of specific identification of the adjusted cost of each security. Amortization of premiums and accretion of discounts for all types of securities are computed using a method approximating a level-yield basis. Loans -- Loans are stated net of unearned discounts, unamortized net loan origination fees and the allowance for loan losses. Interest income is recognized on the accrual basis. The accrual of interest on loans is generally discontinued when loans become 90 days past due or earlier when, in management's judgment, it is determined that 24 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- a reasonable doubt exists as to its collectibility. When a loan is placed on nonaccrual, interest accruals cease and uncollected accrued interest is reversed and charged against current income. Additional interest payments on such loans are applied to principal or recognized in income on a cash basis. A nonaccrual loan may be restored to accrual status when management expects to collect all contractual principal and interest due and the borrower has demonstrated a sustained period of repayment performance in accordance with the contractual terms. Deferred Loan Fees -- Loan origination and commitment fees and related direct-loan origination costs of completed loans are deferred and accreted to income as a yield adjustment over the life of the loan using the level-yield method. The accretion to income is discontinued when a loan is placed on nonaccrual status. When a loan is paid off, any unamortized net deferred-fee balance is credited to income. When a loan is sold, any unamortized net deferred-fee balance is considered in the calculation of gain or loss. Allowance for Loan Losses -- The allowance for loan losses ("allowance") is based on a periodic evaluation of the portfolio and is maintained at a level that management considers adequate to absorb known and inherent losses in the portfolio. Management considers a variety of factors when establishing the allowance, recognizing that an inherent risk of loss always exists in the lending process. Consideration is given to the impact of current economic conditions, diversification of the loan portfolio, historical loss experience, delinquency statistics, results of detailed loan reviews, borrowers' financial and managerial strengths, the adequacy of underlying collateral, and other relevant factors. While management utilizes the latest available information to determine the likelihood for losses on loans, future additions to the allowance may be necessary based on changes in economic conditions as well as adverse changes in the financial condition of borrowers. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance. Such agencies may require DNB to recognize additions to the allowance based on their judgments of information available to them at the time of their examination. The allowance is increased by the provision for loan losses, which is charged to operations. Loan losses are charged directly against the allowance and recoveries on previously charged-off loans are added to the allowance. For purposes of applying the measurement criteria for impaired loans, DNB excludes large groups of smaller-balance homogeneous loans, primarily consisting of residential real estate loans and consumer loans, as well as commercial loans with balances less than $100,000. For applicable loans, management evaluates the need for impairment recognition when a loan becomes nonaccrual, or earlier, if based on an assessment of the relevant facts and circumstances, it is probable that DNB will be unable to collect all proceeds due according to the contractual terms of the loan agreement. DNB's policy for the recognition of interest income on impaired loans is the same as for nonaccrual loans. Impairment is charged to the allowance when management determines that foreclosure is probable or the fair value of the collateral is less than the recorded investment of the impaired loan. Other Real Estate Owned -- Other real estate owned ("OREO") consists of properties acquired as a result of, or in-lieu-of, foreclosure. Properties classified as OREO are reported at the lower of carrying value or fair value, less estimated costs to sell. Costs relating to the development or improvement of the properties are capitalized and costs relating to holding the properties are charged to expense. Office Properties and Equipment -- Office properties and equipment are recorded at cost. Depreciation is computed using the straight-line method over the expected useful lives of the assets. The costs of maintenance and repairs are expensed as they are incurred; renewals and betterments are capitalized. All long-lived assets are reviewed for impairment, based on the fair value of the asset. In addition, long-lived assets to be disposed of are generally reported at the lower of carrying amount or fair value, less costs to sell. Gains or losses on disposition of premises and equipment are reflected in operations. Downingtown National Bank [LOGO] 25 Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- Federal Income Taxes -- DNB accounts for income taxes in accordance with the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. 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 that includes the enactment date. The Corporation files a consolidated Federal income tax return with the Bank. Pension Plan -- The Bank maintains a noncontributory defined benefit pension plan covering substantially all employees over the age of 21 with one year of service. Plan benefits are based on years of service and the employee's monthly average compensation for the highest five consecutive years of their last ten years of service. Stock Option Plan -- SFAS No. 123, Accounting for Stock-Based Compensation ("SFAS No. 123"), permits entities to recognize as expense over the vesting period, the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. DNB has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123. As such, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Earnings Per Share -- Basic earnings per share is computed based on the weighted average number of common shares outstanding during the year. Diluted earnings per share reflects the potential dilution that could occur from the conversion of common stock equivalents and is computed using the treasury stock method. Earnings per share, dividends per share and weighted average shares outstanding have been adjusted to reflect the effects of the 5% stock dividends paid in December 2000, 1999 and 1998 and the September 1997 two-for-one stock split, effected in the form of a 100% dividend. Trust Assets -- Assets held by DNB in fiduciary or agency capacities are not included in the consolidated financial statements since such items are not assets of DNB. Operating income and expenses of the DNB's Trust & Investment Group are included in the consolidated statements of operations and are recorded on an accrual basis. Statements of Cash Flows -- For purposes of the statements of cash flows, DNB considers cash in banks, amounts due from banks, and Federal funds sold to be cash equivalents. Generally, Federal funds are sold for one-day periods. Recent Accounting Pronouncements -- In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which was subsequently amended ("SFAS No. 133"). This statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and those used for hedging activities, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. SFAS No. 133 generally provides for matching of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk, so long as the hedge is effective. Prospective application of SFAS No. 133 is required for all fiscal years beginning after June 15, 2000, however earlier application is permitted. SFAS No. 133 was adopted on January 1, 2001 and there was no impact on operations, financial condition and equity and comprehensive income. DNB currently has no derivatives covered by this statement and currently conducts no hedging activities. 26 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- (2) INVESTMENT SECURITIES Amortized cost and estimated fair values of investment securities, as of the dates indicated, are summarized as follows:
December 31, 2000 ------------------------------------------------------------------- Amortized Unrealized Unrealized Estimated Held to Maturity Cost Gains Losses Fair Value ======================================================================================================================= US Government agency obligations $19,805 $182 $ (21) $19,966 Collateralized mortgage obligations 16,047 19 (118) 15,948 US agency mortgage-backed securities 2,161 3 (26) 2,138 Equity securities 3,316 -- -- 3,316 Other securities 999 -- (9) 990 ----------------------------------------------------------------------------------------------------------------------- Total investment securities $42,328 $204 $ (174) $42,358 ======================================================================================================================= ------------------------------------------------------------------- Amortized Unrealized Unrealized Estimated Available for Sale Cost Gains Losses Fair Value ----------------------------------------------------------------------------------------------------------------------- US Government agency obligations $27,501 $104 $ (42) $27,563 US agency mortgage-backed securities 5,417 36 (19) 5,434 State and municipal tax-exempt 10,146 -- (422) 9,724 Corporate bonds 31,893 129 (1,577) 30,445 DRD agency preferred stock 6,014 8 (2) 6,020 Other securities 6,956 1 (55) 6,902 ----------------------------------------------------------------------------------------------------------------------- Total investment securities $87,927 $278 $(2,117) $86,088 ======================================================================================================================= December 31, 1999 ------------------------------------------------------------------- Amortized Unrealized Unrealized Estimated Held to Maturity Cost Gains Losses Fair Value ----------------------------------------------------------------------------------------------------------------------- US Government agency obligations $14,203 $ 10 $ (375) $13,838 Collateralized mortgage obligations 19,608 -- (368) 19,240 US agency mortgage-backed securities 2,908 2 (54) 2,856 Equity securities 2,965 -- -- 2,965 Other securities 999 -- (29) 970 ----------------------------------------------------------------------------------------------------------------------- Total investment securities $40,683 $ 12 $ (826) $39,869 ======================================================================================================================= ------------------------------------------------------------------- Amortized Unrealized Unrealized Estimated Available for Sale Cost Gains Losses Fair Value ----------------------------------------------------------------------------------------------------------------------- US Government agency obligations $18,920 $ -- $ (257) $18,663 US agency mortgage-backed securities 10,903 16 (109) 10,810 State and municipal tax-exempt 9,629 -- (1,379) 8,250 Corporate bonds 21,548 206 (1,261) 20,493 Other securities 5,011 -- (239) 4,772 ----------------------------------------------------------------------------------------------------------------------- Total investment securities $66,011 $222 $(3,245) $62,988 ======================================================================================================================= Downingtown National Bank [LOGO] 27
Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- The amortized cost and estimated fair value of investment securities as of December 31, 2000, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid without penalties.
Investment Securities Investment Securities Held to Maturity Available for Sale ----------------------------------------------------------------- Amortized Estimated Amortized Estimated (Dollars in thousands) Cost Fair Value Cost Fair Value ----------------------------------------------------------------------------------------------------------------------- Due in one year or less $ 191 $ 191 $ 6,450 $ 6,437 Due after one year through five years 4,040 4,042 14,086 14,143 Due after five years through ten years 8,194 8,324 6,947 6,924 Due after ten years 26,587 26,485 54,430 52,564 No stated maturity 3,316 3,316 6,014 6,020 Total investment securities $42,328 $42,358 $87,927 $86,088
DNB sold $12.5 million and $2.0 million of securities from the AFS portfolio during 2000 and 1998. No securities were sold during 1999. Gains and losses from sales of investment securities were as follows: Year Ended December 31 ---------------------------------- (Dollars in thousands) 2000 1999 1998 ----------------------------------------------------------- Gross realized gains $ 56 $-- $ 5 Gross realized losses 41 -- -- ----------------------------------------------------------- Net realized gain $ 15 $-- $ 5 =========================================================== At December 31, 2000 and 1999, investment securities with a carrying value of approximately $39.3 million and $32.6 million, respectively, were pledged to secure public funds and for other purposes as required by law. (3) LOANS December 31 ----------------------------- (Dollars in thousands) 2000 1999 ======================================================= Residential mortgage $ 43,227 $ 39,873 Commercial mortgage 67,302 57,656 Commercial 41,000 38,734 Consumer 39,672 35,193 ------------------------------------------------------- Total loans 191,201 171,456 ------------------------------------------------------- Less allowance for loan losses (4,917) (5,085) ------------------------------------------------------- Net loans $186,284 $166,371 ======================================================= Included in the loan portfolio are loans for which DNB has ceased the accrual of interest. Loans of approximately $1.2 million, $1.3 million and $2.4 million as of December 31, 2000, 1999 and 1998, respectively, were on a nonaccrual basis. DNB also had loans of approximately $609,000, $694,000 and $700,000 that were more than 90 days delinquent, but still accruing as of December 31, 2000, 1999 and 1998, respectively. If contractual interest income had been recorded on nonaccrual loans, interest would have been increased as shown in the following table: Year Ended December 31 ------------------------------- (Dollars in thousands) 2000 1999 1998 ========================================================= Interest income which would have been recorded under original terms $ 98 $105 $194 Interest income recorded during the year (21) (21) (92) --------------------------------------------------------- Net impact on interest income $ 77 $ 84 $102 ========================================================= DNB had $8.0 million of loans which, although performing at December 31, 2000, are believed to require increased supervision and review, and may, depending on the economic environment and other factors, become non-performing assets in future periods. There were $7.9 million of such loans at December 31, 1999. The majority of the loans are secured by commercial real estate with lesser amounts being secured by residential real estate, inventory and receivables. 28 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- Although DNB has a significant concentration of residential and commercial mortgage loans collateralized by first mortgage liens located in Chester County, DNB has no concentration of loans to borrowers engaged in similar activities which exceed 10% of total loans at December 31, 2000, except for loans of approximately $24.8 million relating to local multi-unit office buildings and $28.1 million to the HealthCare sector. DNB also had loans of approximately $16.5 million to local residential real estate developers at December 31, 2000. (4) ALLOWANCE FOR LOAN LOSSES Changes in the allowance for loan losses, for the years indicated, are as follows: Year Ended December 31 ---------------------------------- (Dollars in thousands) 2000 1999 1998 ========================================================== Beginning balance $5,085 $5,205 $5,281 Provisions -- -- -- Loans charged off (224) (216) (303) Recoveries 56 96 227 ---------------------------------------------------------- Net charge-offs (168) (120) (76) ---------------------------------------------------------- Ending balance $4,917 $5,085 $5,205 ========================================================== At December 31, 2000, 1999 and 1998, DNB had impaired loans with total recorded investments of $651,000, $715,000 and $1.7 million and an average recorded investments of $693,000, $1.0 million and $1.6 million for the years ended December 31, 2000, 1999 and 1998. Total cash collected on impaired loans was credited to the outstanding principal balance in the amounts of $25,000, $113,000 and $68,000 during the years ended December 31, 2000, 1999 and 1998. No interest income was recorded on such loans during the three years ended December 31, 2000. (5) OFFICE PROPERTY AND EQUIPMENT December 31 -------------------------------------------- Estimated (Dollars in thousands) Useful Lives 2000 1999 ====================================================================== Land $ 935 $ 935 Buildings 25-33 years 4,905 4,853 Furniture, fixtures and equipment 5-20 years 6,800 6,157 ---------------------------------------------------------------------- Total cost 12,640 11,945 Less accumulated depreciation (6,751) (6,169) ---------------------------------------------------------------------- Office property and equipment, net $ 5,889 $ 5,776 ====================================================================== Amounts charged to operating expense for depreciation for the years ended December 31, 2000, 1999 and 1998 amounted to $687,000, $637,000 and $412,000 respectively. (6) DEPOSITS Included in interest-bearing time deposits are certificates of deposit issued in amounts of $100,000 or more. These certificates and their remaining maturities were as follows: December 31 ------------------------- (Dollars in thousands) 2000 1999 ========================================================= Three months or less $10,118 $ 8,985 Over three through six months 8,934 12,671 Over six through twelve months 6,419 2,585 Over one year through two years 4,184 1,814 Over two years 106 1,324 --------------------------------------------------------- Total $29,761 $27,379 ========================================================= (7) FHLB ADVANCES AND SHORT TERM BORROWED FUNDS DNB's short-term borrowed funds consist of Federal funds purchased and repurchase agreements. Federal funds purchased generally represent one-day borrowings. Securities sold under repurchase agreements represent overnight borrowings that are secured by U.S. Agency securities. DNB had an average of $171,000 outstanding in short-term borrowed funds during 2000, and no such borrowings during 1999. In addition to Federal funds purchased, DNB maintains borrowing arrangements with a correspondent bank and the Federal Home Loan Bank Downingtown National Bank [LOGO] 29 Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- (FHLB) of Pittsburgh. As of September 30, 2000 DNB has a maximum borrowing capacity at the FHLB of approximately $106.9 million. All advances were convertible term advances, which mature at various dates through the year ended December 31, 2010, as shown in the table below. Advances are callable, at the FHLB's option, at various dates starting on January 31, 2001 and ending on October 20, 2004. If an advance is called by the FHLB, DNB has the option of repaying the borrowing, or it may continue to borrow at three month Libor plus 10-14 basis points. FHLB advances are collateralized by a pledge of the Bank's entire portfolio of unencumbered investment securities, certain mortgage loans and a lien on the Bank's FHLB stock. ------------------------------- (Dollars in thousands) December 31, 2000 ========================================================= Due by Weighted December 31st Average Rate Amount ========================================================= 2005 5.78% $ 3,000 Thereafter 6.04 37,000 --------------------------------------------------------- Total 6.02% $40,000 ========================================================= (8) CAPITAL LEASE OBLIGATIONS Included in other borrowings is a long-term capital lease agreement, which relates to DNB's West Goshen branch. As of December 31, 2000 the branch has a carrying amount of $694,000, net of accumulated depreciation of $56,000, and is included in the balance of office properties and equipment in the accompanying statements of financial condition. The following is a schedule of the future minimum lease payments, together with the present value of the net minimum lease payments, as of December 31, 2000: (Dollars in thousands) ----------- Year ending December 31 Amount ======================================================= 2001 $ 79 2002 81 2003 84 2004 86 2005 89 Thereafter 1,887 ======================================================= Total minimum lease payments 2,306 Less amount representing interest (1,565) ======================================================= Present value of net minimum lease payments $ 741 ======================================================= (9) FAIR VALUE OF FINANCIAL INSTRUMENTS Fair value assumptions, methods, and estimates are set forth below for DNB's financial instruments. Limitations Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time DNB's entire holdings of a particular financial instrument. Because no market exists for a significant portion of DNB's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The following methods and assumptions were used to estimate the fair value of each class of financial instruments. Cash, Federal Funds Sold and Investment Securities The carrying amounts for short-term investments (cash and Federal funds sold) approximates fair value. The fair value of investment securities is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers. The carrying amount of non-readily marketable equity securities approximates liquidation value. Loans Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial mortgages, residential mortgages, consumer and student loans, and nonaccrual loans. The fair value of performing loans is calculated by discounting expected cash flows using an 30 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- estimated market discount rate. Expected cash flows include both contractual cash flows and prepayments of loan balances. Prepayments on consumer loans were determined using the median of estimates of securities dealers for mortgage-backed investment pools. The estimated discount rate considers credit and interest rate risk inherent in the loan portfolios and other factors such as liquidity premiums and incremental servicing costs to an investor. Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented below would be indicative of the value negotiated in an actual sale. The fair value for nonaccrual loans was derived through a discounted cash flow analysis, which includes the opportunity costs of carrying a non-performing asset. An estimated discount rate was used for all nonaccrual loans, based on the probability of loss and the expected time to recovery. Deposits and Borrowings The fair value of deposits with no stated maturity, such as non-interest-bearing deposits, savings, NOW and money market accounts, is equal to the amount payable on demand as of December 31, 2000 and 1999. The fair values of certificates of deposit and borrowings are based on the present value of contractual cash flows. The discount rates used to compute present values are estimated using the rates currently offered for deposits of similar maturities in DNB's marketplace and rates currently being offered for borrowings of similar maturities. Off-balance-sheet Instruments Off-balance-sheet instruments are primarily comprised of loan commitments which are generally priced at market at the time of funding. Fees on commitments to extend credit and standby letters of credit are deemed to be immaterial and these instruments are expected to be settled at face value or expire unused. It is impractical to assign any fair value to these instruments. At December 31, 2000 and 1999, loan commitments were $28.6 million and $26.6 million, respectively. Stand-by letters of credit were $5.8 million and $2.6 million at December 31, 2000 and 1999, respectively. The following tables summarize information for all on-balance-sheet financial instruments.
December 31 2000 1999 ---------------------------------------------------------------------------------------------- Estimated Estimated Carrying Fair Carrying Fair (Dollars in thousands) Amount Value Amount Value ============================================================================================== Financial assets Cash and Federal funds sold $ 27,352 $ 27,352 $ 17,530 $ 17,530 Investment securities, AFS 86,088 86,088 62,988 62,988 Investment securities, HTM 42,328 42,358 40,683 39,869 Net loans 186,284 184,875 166,371 163,710 Accrued interest receivable 2,580 2,580 1,804 1,804 Financial liabilities Deposits 290,791 291,365 254,881 254,862 Borrowings 40,741 42,729 23,746 23,461 Accrued interest payable 1,450 1,450 1,078 1,078 ==============================================================================================
(10) FEDERAL INCOME TAXES Income tax expense was comprised of the following: Year Ended December 31 (Dollars in thousands) 2000 1999 1998 ----------------------------------------------------------------------- Current tax expense $ 865 $1,220 $1,327 Deferred income tax expense (benefit) 198 26 (75) ----------------------------------------------------------------------- Income tax expense $1,063 $1,246 $1,252 ----------------------------------------------------------------------- The effective income tax rates of 28% for 2000, 31% for 1999 and 30% for 1998 were less than the applicable statutory Federal income tax rate. The reason for these differences follows: Year Ended December 31 --------------------------------- (Dollars in thousands) 2000 1999 1998 ==================================================================== Federal income taxes at statutory rate $1,282 $1,386 $1,419 Decrease resulting from: Low income housing credits (24) -- -- Tax-exempt interest income (160) (147) (58) Bank owned life insurance (20) -- -- Other, net (15) 7 (109) -------------------------------------------------------------------- Income tax expense $1,063 $1,246 $1,252 ==================================================================== Downingtown National Bank [LOGO] 31 Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below: December 31 ----------------------- (Dollars in thousands) 2000 1999 ======================================================= Deferred tax assets: Allowance for loan losses $1,672 $1,572 Valuation adjustment for debt securities 590 968 Other 99 222 ------------------------------------------------------- Total gross deferred tax assets 2,361 2,762 Deferred tax liabilities: Depreciation (210) (120) Pension expense (412) (407) Tax bad debt reserve (142) (142) Other (170) (91) ------------------------------------------------------- Total gross deferred tax liabilities (934) (760) ------------------------------------------------------- Net deferred tax asset $1,427 $2,002 ======================================================= Based upon DNB's current and historical tax history and the anticipated level of future taxable income, management believes the existing net deferred tax asset will, more likely than not, be realized based on future taxable income. (11) EARNINGS PER SHARE Options to purchase 28,531 shares of common stock at $16.67 per share have been out-standing since June 30, 1997, but were not included in the computation of diluted EPS for 2000 because these options were anti-dilutive during such period. The options, which expire on June 30, 2007 were still outstanding at December 31, 2000. Options to purchase 32,281 shares of common stock in 2000 and 33,847 shares of common stock in 1999 at $30.45 per share have been outstanding since June 30, 1998, but were not included in the computation of diluted EPS for 2000 and 1999 because these options were anti-dilutive during such periods. The options, which expire on June 30, 2008 were still outstanding at December 31, 2000. Also, options to purchase 27,065 shares of common stock in 2000 and 28,329 shares of common stock in 1999 at $24.49 per share have been outstanding since June 30, 1999, but were not included in the computation of diluted EPS for 2000 and 1999 because these options were anti-dilutive during such periods. These options which expire on June 30, 2009 were still outstanding at December 31, 2000. (11) EARNINGS PER SHARE The following is a reconcilement of net income and the weighted average number of shares outstanding for basic and diluted EPS:
Year Ended December 31 -------------------------------------------------------------------------------------------- 2000 1999 1998 -------------------------------------------------------------------------------------------- Income Shares Amount Income Shares Amount Income Shares Amount ====================================================================================================================== Basic EPS Income available to common stockholders $2,708 1,691 $1.60 $2,832 1,684 $1.68 $2,922 1,681 $1.74 Effect of dilutive common stock equivalents - stock options -- 23 0.02 -- 57 0.05 -- 73 0.07 ----------------------------------------------------------------------------------------------------------------------- Diluted EPS Income available to common stockholders after assumed conversions 2,708 1,714 $1.58 $2,832 1,741 $1.63 $2,922 1,754 $1.67 ======================================================================================================================
32 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- (12) OTHER COMPREHENSIVE INCOME The tax effects allocated to each component of "Other Comprehensive Income" are as follows: ------------------------------------ Tax Before-Tax (Expense) Net-of-Tax (Dollars in thousands) Amount Benefit Amount ========================================================================= Year Ended December 31, 2000: Unrealized gains on securities: Unrealized holding gains arising during the period $ 1,199 $(383) $ 816 Less reclassification for gains included in net income (15) 5 (10) ========================================================================= Other Comprehensive Income $ 1,184 $(378) $ 806 ========================================================================= Year Ended December 31, 1999: Unrealized losses on securities: Unrealized holding losses arising during the period $(3,098) $ 990 $(2,108) Less reclassification for losses included in net income -- -- -- ------------------------------------------------------------------------- Other Comprehensive Income $(3,098) $ 990 $(2,108) ========================================================================= Year Ended December 31, 1998: Unrealized gains on securities: Unrealized holding gains arising during the period $ 53 $ (18) $ 35 Less reclassification for gains included in net income (5) 2 (3) ------------------------------------------------------------------------- Other Comprehensive Income $ 48 $ (16) $ 32 ========================================================================= (13) BENEFIT PLANS Pension Plan Qualified - The Bank maintains a pension plan (the "Plan") covering all employees, including officers, who have been employed for one year and have attained 21 years of age. Prior to May 1, 1985, an individual must have attained the age of 25 and accrued one year of service. The Plan provides pension benefits to eligible retired employees at 65 years of age equal to 1.5% of their average monthly pay multiplied by their years of accredited service. The accrued benefit is based on the monthly average of their highest five consecutive years of their last ten years of service. The following table sets forth the Plan's funded status, as of the measurement dates of December 31, 2000 and 1999 and amounts recognized in DNB's consolidated financial statements at December 31, 2000 and 1999: December 31 ----------------------------- (Dollars in thousands) 2000 1999 ======================================================================== Actuarial present value of benefit obligation: Vested benefit obligation $(3,955) $(3,896) ------------------------------------------------------------------------ Accumulated benefit obligation (4,037) (3,956) ------------------------------------------------------------------------ Projected benefit obligation (4,427) (4,408) Plan assets at fair value 6,243 5,849 ------------------------------------------------------------------------ Projected benefit obligation over plan assets 1,816 1,441 Unrecognized net asset at January 1, 1987 being amortized over 17 years (75) (94) Unrecognized net (gain) loss (523) (137) ------------------------------------------------------------------------ Prepaid pension cost included in other assets $ 1,218 $ 1,210 ======================================================================== Net periodic pension (benefit) costs for the years indicated include the following components: Year Ended December 31 ---------------------------------- (Dollars in thousands) 2000 1999 1998 ====================================================================== Service cost-benefits earned during the period $ 199 $ 183 $ 180 Interest cost on projected benefit obligation 302 297 296 Actual return on plan assets (563) (230) (103) Asset gain (loss) 74 (247) (361) Amortization of unrecognized net asset at transition (19) (19) (18) Amortization of unrecognized net loss after transition -- -- -- ---------------------------------------------------------------------- Net pension benefit $ (7) $ (16) $ (6) ====================================================================== Assumptions used: Discount rate 7.00% 7.00% 7.00% Rate of increase in compensation level 5.00 5.00 5.00 Expected long-term rate of return on assets 8.50 8.50 8.50 ====================================================================== The Pension Plan's assets are invested using an asset allocation strategy in units of certain equity, bond, real estate and money market funds. Downingtown National Bank [LOGO] 33 Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- DNB adopted an arrangement for supplemental compensation (the "Supplemental Plan") for its Chief Executive Officer (the "Executive") during 1999. The Supplemental Plan provides that the Bank and the Executive share in the rights to the cash surrender value and death benefits of a split-dollar life insurance policy (the "Split-dollar Policy") and provides for additional compensation to the Executive, equal to any income tax consequences related to the Supplemental Plan until retirement. The Split-dollar Policy is designed to provide the Executive, upon attaining age 65, with projected annual after-tax distributions of approximately $35,000, funded by loans against the cash surrender value of the Split-dollar Policy. In addition, the Split-dollar Policy is intended to provide the Executive with a projected death benefit of $750,000. Neither the insurance company nor DNB has guaranteed any minimum cash value under the Supplemental Plan. To fund the annual premium on the Split-dollar Policy and mitigate the obligations under this Plan, the Bank has purchased an additional life insurance policy on the Executive's life (the "BOLI Policy") with an initial deposit of $1.5 million ($1.6 million market value at December 31, 2000). The amount of the BOLI Policy has been calculated so that the projected increases in its cash surrender value will substantially offset the Bank's expense related to the Split-dollar Policy. 401(k) Retirement Savings Plan The Bank's retirement savings plan enables employees to become eligible to participate after six months of service, and will thereafter participate in the 401(k) plan for any year in which they have been employed for at least 501 hours. In general, amounts held in a participant's account are not distributable until the participant terminates employment, reaches age 59 1/2, dies or becomes permanently disabled. Participants are permitted to authorize pre-tax savings contributions to a separate trust established under the 401(k) plan, subject to limitations on deductibility of contributions imposed by the Internal Revenue Code. The Bank makes matching contributions of $.25 for every dollar of deferred salary up to 6% of each participant's annual compensation. Each participant is 100% vested at all times in employee and employer contributions. The matching contributions to the 401(k) plan were $41,000, $35,000 and $33,000 in 2000, 1999 and 1998, respectively. Stock Option Plan DNB has a Stock Option Plan for employees and directors. Under the plan, options (both qualified and non-qualified) to purchase a maximum of 284,461 shares of DNB's common stock could be issued to employees and directors. On February 24, 1999, the Board of Directors of the Corporation amended and restated DNB Financial Corporation's 1995 Stock Option Plan (the "Plan"), to increase by 100,000 the number of shares for which options may be issued under the Plan. This amendment was approved by shareholders at the April 27, 1999 Annual Meeting. Under the plan, option exercise prices must equal the fair market value of the shares on the date of option grant and the option exercise period may not exceed ten years. Vesting of options under the plan is determined by the Plan Committee. There were 91,121 and 133,808 shares available for grant at December 31, 2000 and 1999, respectively. At December 31, 2000 and 1999, the number of options exercisable was 176,103 and 156,955, respectively, and the weighted average exercise price of those options was $17.54 and $18.70, respectively. The per share weighted-average fair value of stock options granted during 2000, 1999 and 1998 was $3.14, $7.95 and $8.61 on the date of grant using the Black Scholes option-pricing model with the following weighted-average assumptions: for 2000-expected dividend yield of 3.48%, risk-free interest rate of 5.02%, expected life of 9.5 years and an expected volatility of stock over the expected life of the options was 24%; for 1999-expected dividend yield of 1.88%, risk-free interest rate of 6.44%, expected life of 9.5 years and an expected volatility of stock over the expected life of the options of 16%; for 1998-expected dividend yield of 1.39%, risk-free interest rate of 4.82%, expected life of 9.5 years and an expected volatility of stock over the expected life of the options of 14%. DNB applies APB Opinion No. 25 in accounting for its Stock Option Plan, and accordingly, no compensation cost has been recognized for its stock options in the financial statements. 34 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- Had DNB determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, DNB's net income and earnings per share would have been reduced to the pro forma amounts indicated below: Year Ended December 31 ------------------------------------ 2000 1999 1998 ----------------------------------------------------------- Net income as reported $2,708 $2,832 $2,922 pro forma 2,615 2,617 2,644 Diluted net income per share as reported $1.58 $1.63 $1.67 pro forma 1.53 1.50 1.51 ----------------------------------------------------------- Stock option activity is indicated below. Shares have been adjusted for the 2 for 1 stock split in September 1997 and the 5% stock dividends in December of 2000, 1999 and 1998. ---------------------------------- Number Weighted Average Outstanding Exercise Price ================================================================== Outstanding, January 1, 1998 110,856 $12.18 Granted 35,501 30.45 Exercised (2,301) 8.49 ------------------------------------------------------------------ Outstanding, December 31, 1998 144,056 17.13 Granted 29,475 24.49 Exercised (14,839) 8.49 Terminated (1,737) 30.45 ------------------------------------------------------------------ Outstanding, December 31, 1999 156,955 18.70 Granted 29,736 12.98 Exercised (1,970) 8.49 Terminated (8,618) 24.31 ================================================================== Outstanding, December 31, 2000 176,103 $17.54 ================================================================== The weighted average price and weighted average remaining contractual life for the outstanding options are listed below for the dates indicated. All outstanding options are exercisable. December 31, 2000 ----------------------------------------------------------------------- Range of Number Weighted Average Exercise Prices Outstanding Remaining Contractual Life ======================================================================= $8.49-$11.46 58,490 5.0 years 16.67 28,531 6.5 years 30.45 32,281 7.5 years 24.49 27,065 8.5 years 12.98 29,736 9.5 years --------- ----------- 176,103 7.0 years ======================================================================= December 31, 1999 ----------------------------------------------------------------------- Range of Number Weighted Average Exercise Prices Outstanding Remaining Contractual Life ======================================================================= $ 8.49-$11.46 60,459 6.0 years 16.67 31,210 7.5 years 30.45 35,540 8.5 years 24.49 29,746 9.5 years --------- ----------- 156,955 7.5 years ======================================================================= (14) COMMITMENTS, CONTINGENT LIABILITIES AND OFF-BALANCE-SHEET RISK In the normal course of business, various commitments and contingent liabilities are outstanding, such as guarantees and commitments to extend credit, borrow money or act in a fiduciary capacity, which are not reflected in the consolidated financial statements. Management does not anticipate any significant losses as a result of these commitments. DNB had outstanding standby letters of credit in the amount of approximately $5.8 million and unfunded loan and lines of credit commitments in the amount of approximately $28.6 million at December 31, 2000. Of the $28.6 million, $24.6 million was for variable rate loans and $4.0 million was for fixed rate loans. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheet. The exposure to credit loss in the event of non-performance by the party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount. Management uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Standby letters of credit are conditional commitments issued by DNB to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risks involved in issuing letters of credit are essentially the same as those involved in extending loan facilities to customers. DNB holds various collateral to support these commitments. Commitments to extend credit are agreements to lend to a customer as long as there is Downingtown National Bank [LOGO] 35 Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. DNB evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral, if any, obtained upon the extension of credit, usually consists of real estate, but may include securities, property or other assets. DNB maintains borrowing arrangements with a correspondent bank and the FHLB of Pittsburgh, as well as access to the discount window at the Federal Reserve Bank of Philadelphia to meet short-term liquidity needs. Through these relationships, DNB has available short-term credit of approximately $74.4 million. Approximately $86.4 million of assets are held by DNB's Trust and Investment Group in a fiduciary or agency capacity. These assets are not assets of DNB, and are not included in the consolidated financial statements. DNB is a party to a number of lawsuits arising in the ordinary course of business. While any litigation causes an element of uncertainty, management is of the opinion that the liability, if any, resulting from the actions, will not have a material effect on the accompanying financial statements. (15) PARENT COMPANY FINANCIAL INFORMATION Condensed financial information of DNB Financial Corporation (parent company only) follows: Condensed Statements of Financial Condition December 31 ------------------------------- (Dollars in thousands) 2000 1999 ======================================================================= Assets Investment in subsidiary $23,230 $20,538 ======================================================================= Total assets $23,230 $20,538 ======================================================================= Liabilities and Stockholders' Equity Liabilities Dividends payable to stockholders $-- $-- ----------------------------------------------------------------------- Total liabilities -- -- ----------------------------------------------------------------------- Stockholders' Equity Total stockholders' equity 23,230 20,538 ----------------------------------------------------------------------- Total liabilities and stockholders' equity $23,230 $20,538 ======================================================================= Condensed Statements of Operations Year Ended December 31 ------------------------------ (Dollars in thousands) 2000 1999 1998 =============================================================== Income: Dividends from subsidiary $ 838 $ 801 $ 707 Equity in undistributed income of subsidiary 1,870 2,031 2,215 --------------------------------------------------------------- Net income $2,708 $2,832 $2,922 =============================================================== Condensed Statements of Cash Flows Year Ended December 31 --------------------------------------- (Dollars in thousands) 2000 1999 1998 ======================================================================= Cash Flows From Operating Activities: Net income $ 2,708 $ 2,832 $ 2,922 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed income of subsidiary (1,870) (2,031) (2,215) ----------------------------------------------------------------------- Net Cash Provided by Operating Activities 838 801 707 ----------------------------------------------------------------------- Cash Flows From Investing Activities: Purchase of Bank subsidiary stock (16) (9) (3) ----------------------------------------------------------------------- Net Cash Used In Investing Activities (16) (9) (3) Cash Flows From Financing Activities: Dividends paid (838) (801) (707) Proceeds from issuance of stock under Stock Option Plan 16 9 3 ----------------------------------------------------------------------- Net Cash Used in Financing Activities (822) (792) (704) ----------------------------------------------------------------------- Net Change in Cash and Cash Equivalents $-- $-- $-- ======================================================================= 36 Downingtown National Bank [LOGO] Notes to Consolidated Financial Statements -------------------------------------------------------------------------------- (16) REGULATORY MATTERS Dividends payable to the Corporation by the Bank are subject to certain regulatory limitations. Under normal circumstances, the payment of dividends in any year without regulatory permission is limited to the net profits (as defined for regulatory purposes) for that year, plus the retained net profits for the preceding two calendar years, which amounted to $6.1 million for the year ended December 31, 2000. Federal banking agencies impose three minimum capital requirements on DNB -- risk-based capital ratios based on total capital, "Tier 1" capital, and a leverage capital ratio. The risk-based capital ratios measure the adequacy of a bank's capital against the riskiness of its assets and off-balance sheet activities. Failure to maintain adequate capital is a basis for "prompt corrective action" or other regulatory enforcement action. In assessing a bank's capital adequacy, regulators also consider other factors such as interest rate risk exposure; liquidity, funding and market risks; quality and level of earnings; concentrations of credit, quality of loans and investments; risks of any nontraditional activities; effectiveness of bank policies; and management's overall ability to monitor and control risks. Quantitative measures established by regulation to ensure capital adequacy require DNB to maintain certain minimum amounts and ratios as set forth below. Management believes that DNB and the Bank meet all capital adequacy requirements to which they are subject. The Bank is considered "Well Capitalized" under the regulatory framework for prompt corrective action. To be categorized as Well Capitalized, the Bank must maintain minimum ratios as set forth below. There are no conditions or events since that notification, that management believes would have changed the Bank's category. Actual capital amounts and ratios are presented below.
To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions ----------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio ======================================================================================================================= December 31, 2000: Total risk-based capital $26,975 10.78% $20,016 8.00% $25,020 10.00% Tier 1 capital 23,825 9.52 10,008 4.00 15,012 6.00 Tier 1 (leverage) capital 23,825 6.90 13,805 4.00 17,256 5.00 ----------------------------------------------------------------------------------------------------------------------- December 31, 1999: Total risk-based capital $24,534 11.74% $16,724 8.00% $20,905 10.00% Tier 1 capital 21,890 10.47 8,362 4.00 12,543 6.00 Tier 1 (leverage) capital 21,890 7.26 12,085 4.00 15,107 5.00 ======================================================================================================================= Downingtown National Bank [LOGO] 37
Independent Auditors' Report KPMG Market Street Philadelphia, PA 19103-7212 The Board of Directors and Stockholders DNB Financial Corporation: We have audited the accompanying consolidated statements of financial condition of DNB Financial Corporation and subsidiary as of December 31, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2000. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of DNB Financial Corporation and subsidiary as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. /s/ KPMG LLP January 19, 2001 Philadelphia, PA KPMG LLP. KPMG LLP, a U.S. limited liability partnership, is a member of KPMG International, a Swiss association. 38 Downingtown National Bank [LOGO] DNB Financial Corporation and Subsidiary Dnb Financial Corporation Directors Robert J. Charles Chairman Vernon J. Jameson Vice Chairman Thomas R. Greenleaf William S. Latoff Joseph G. Riper Louis N. Teti Henry F. Thorne James H. Thornton Directors Emeritus Ellis Y. Brown, III Paul F. DiMatteo I. Newton Evans, Jr. Ilario S. Polite Officers Henry F. Thorne President and CEO Ronald K. Dankanich Secretary Bruce E. Moroney Chief Financial Officer Downingtown National Bank Officers Henry F. Thorne President and CEO Richard L. Bergey Senior Vice President/ Senior Loan Officer Ronald K. Dankanich Senior Vice President/ Operations and Secretary Charles E. Bradford Senior Vice President & Director DNB Trust & Investment Group Eileen M. Knott Senior Vice President/ Auditor and Compliance Officer Bruce E. Moroney Senior Vice President and CFO Joseph M. Stauffer Senior Vice President/ Retail Banking and Marketing Departments Elizabeth B. Barr Vice President/Construction Lending David L. Binder Vice President/Commercial Lending William W. Brown Vice President/Data Processing Elizabeth A. Cook Asst. Vice President/ Marketing Manager Dominick A. Frederick Vice President/Central Operations Charles H. Fulton Asst. Vice President/ Consumer Lending Michelle L. Griffith Assistant Controller Kenneth R. Kramer Vice President/Retail Lending Timothy J. Mahan Asst. Vice President/ Loan Operations Manager Debora A. Micka Vice President/Commercial Lending Charles S. Moore Vice President/Commercial Lending Ted B. Nichols Vice President/Commercial Lending Tracy E. Panati Asst. Vice President/Human Resources M. Esther Popjoy Vice President/Reconcilements Barry A. Schmidt Vice President/Commercial Lending and Cash Management Charles E. Wuertz Vice President/Commercial Lending Downingtown National Bank [LOGO] 39 Corporate Headquarters 4 Brandywine Avenue Downingtown, PA 19335 Tel. 610-269-1040 Fax 610-873-5298 Internet http://www.dnb4you.com Financial Information Investors, brokers, security analysts and others desiring financial information should contact Bruce Moroney at 610-873-5253 or bmoroney@dnb4you.com. Auditors KPMG LLP 1600 Market Street Philadelphia, PA 19103 Counsel Stradley, Ronon, Stevens and Young, LLP 30 Valley Stream Parkway Malvern, PA 19355 Registrar and Stock Transfer Agent Registrar and Transfer Company 10 Commerce Drive Cranford, NJ 07016 800-368-5948 Market Makers F. J. Morrissey & Company, Inc. 800-842-8928 Herzog, Heine, Geduld, Inc. 215-972-0860 Janney Montgomery Scott, Inc. 800-526-6397 Ryan Beck & Company 800-223-8969 Tucker Anthony Cleary Gull 800-456-9234 DNB Trust & Investment Group 610-269-4657 Charles E. Bradford Sr. Vice President & Director Cheryl T. Burkey Vice President/Trust Officer Community Offices Main Office 610-269-1040 Wanda G. Mize Vice President and Manager Caln Office 610-383-7562 Toni M. Miller Community Banking Officer and Manager East End Office 610-269-3800 Christine M. Beam Assistant Vice President and Manager Kennett Square Office 610-444-4350 C. Ray Cornell Assistant Vice President and Manager Lionville Office 610-363-7590 Joseph J. Bucciaglia Vice President and Manager Little Washington Office 610-942-3666 John R. Rode Vice President and Manager Ludwig's Corner Office 610-458-5100 Joseph J. Bucciaglia Vice President and Manager West Goshen Office 610-429-5860 Clifford Purse Assistant Vice President and Manager Opening Soon: Exton Office (at the former Guernsey Cow Site) 410 Exton Square Parkway Exton, PA 19341