NORWOOD FINANCIAL CORP (NWFL) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations.

Introduction

This Management’s Discussion and Analysis and related financial data are presented to assist in the understanding and evaluation of the financial condition and results of operations for the Company and the Bank, as of December 31, 2022 and 2021, and for the years ended December 31, 2022 and 2021. This section should be read in conjunction with the consolidated financial statements and related footnotes.

Critical Accounting Policies

Note 2 to the Company’s consolidated financial statements lists significant accounting policies used in the development and presentation of its financial statements. This discussion and analysis, the significant accounting policies, and other financial statement disclosures identify and address key variables and other qualitative and quantitative factors that are necessary for an understanding and evaluation of the Company and its results of operations.

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Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets, the determination of other-than-temporary impairment on securities, the determination of goodwill impairment and the fair value of financial instruments. Please refer to the discussion of the allowance for loan losses calculation under “Allowance for Loan Losses and Non-performing Assets” in the “Financial Condition” section.

The deferred income taxes reflect temporary differences in the recognition of the revenue and expenses for tax reporting and financial statement purposes, principally because certain items are recognized in different periods for financial reporting and tax return purposes. Although realization is not assured, the Company believes it is more likely than not that all deferred tax assets will be realized.

In estimating other-than-temporary impairment losses on securities, the Company considers 1) the length of time and extent to which the fair value has been less than cost and 2) the financial condition of the issuer. The Company does not have the intent to sell these securities and it is more likely than not that it will not sell the securities before recovery of their cost basis. The Company believes that any unrealized losses at December 31, 2022 and 2021 represent temporary impairment of the securities.

The fair value of financial instruments is based upon quoted market prices, when available. For those instances where a quoted price is not available, fair values are based upon observable market based parameters, as well as unobservable parameters. Any such valuation is applied consistently over time.

In connection with the acquisition of North Penn in 2011, we recorded goodwill in the amount of $9.7 million, representing the excess of amounts paid over the fair value of the net assets of the institution acquired at the date of acquisition. In connection with the acquisition of Delaware in 2016, we recorded goodwill in the amount of $1.6 million, representing the excess of amounts paid over the fair value of the net assets of the institution acquired at the date of acquisition. In connection with the acquisition of UpState in July 2020, we recorded goodwill in the amount of $17.9 million, representing the excess of amounts paid over the fair value of the net assets of the institution acquired at the date of acquisition. Goodwill is tested annually and deemed impaired when the carrying value of goodwill exceeds its implied fair value.

FINANCIAL CONDITION

Total Assets

Total assets as of December 31, 2022 were $2.047 billion compared to $2.069 billion as of year-end 2021, a decrease of $21.4 million. The decrease in assets was primarily attributable to the $182.6 million decrease in interest-bearing deposits with banks.

Loans Receivable

As of December 31, 2022, loans receivable totaled $1.474 billion compared to $1.355 billion as of year-end 2021, an increase of $119.0 million due primarily to a $53.7 million increase in consumer loans. Commercial real estate loans increased $22.8 million, while residential mortgage loans increased $25.8 million during the year.

The Bank’s loan products include loans for personal and business use. Personal lending includes mortgage lending to finance principal residences and, to a lesser extent, second home dwellings. The Bank’s loan products include fixed-rate mortgage products with terms up to 30 years which may be sold in the secondary market through the Federal National Mortgage Association (“Fannie Mae”) or the FHLB, or held in the Bank’s portfolio to the extent consistent with our asset/liability management strategies. Fixed-rate home equity loans are originated on terms up to 180 months. Home equity lines of credit tied to the prime rate are also offered. The Bank also offers indirect dealer financing of automobiles (new and used), boats, and recreational vehicles through a limited network of dealers in Northeast Pennsylvania and the Southern Tier of New York. At December 31, 2022, there were $188.4 million of indirect loans in the portfolio. In connection with the acquisition of UpState in 2020, the Company acquired approximately $413.5 million in loans, including $37.3 million in residential real estate loans, $289.0 million in commercial real estate loans, $92.0 million in commercial, financial and agricultural loans, and $2.3 million in consumer loans. As of December 31, 2022, the approximate outstanding balance of these acquired loans was $233.3 million. In connection with the acquisition of Delaware, the Company acquired approximately $116.7 million in loans, including $68.7 million in residential real estate loans, $22.5 million in commercial real estate loans, $13.6 million in commercial, financial and agricultural loans, $6.5 million in consumer loans and $5.4 in construction loans. As of December 31, 2022, the approximate outstanding balance of these acquired loans was $30.7 million.

Commercial loans and commercial mortgages are provided to local small and mid-sized businesses at a variety of terms and rate structures. Commercial lending activities include lines of credit, revolving credit, term loans, mortgages, various forms of secured lending and a limited amount of letter of credit facilities. The rate structure may be fixed, immediately repricing tied to the prime rate or adjustable at set intervals. Also included in commercial loans are municipal finance lending in which the Bank has been active in recent years. Municipal lending includes both general obligations of local taxing authorities and revenue obligations of specific revenue

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producing projects such as sewer authorities and educational units. At December 31, 2022, the Bank had approximately $141.9 million in loans on commercial rentals, as well as $113.0 million of loans outstanding on residential rentals, which are its largest lending concentrations.

The Bank’s construction lending has primarily involved lending for commercial construction projects and for single-family residences. All loans for the construction of speculative sale homes have a loan-to-value ratio of not more than 80%. For both commercial and single-family projects, loan proceeds are disbursed during the construction phase according to a draw schedule based on the stage of completion. Construction projects are inspected by contracted inspectors or bank personnel. Construction loans are underwritten on the basis of the estimated value of the property as completed. For commercial projects, the Bank typically also provides the permanent financing after the construction period, as a commercial mortgage.

The Bank also, from time to time, originates loans secured by undeveloped land. Land loans granted to individuals have a term of up to five years. Land loans granted to developers may have an interest only period during development. The substantial majority of land loans have a loan-to-value ratio not exceeding 75%. The Bank has limited its exposure to land loans but may expand its lending on raw land, as market conditions allow, to qualified borrowers experienced in the development and sale of raw land.

Loans involving construction financing and loans on raw land have a higher level of risk than loans for the purchase of existing homes since collateral values, land values, development costs and construction costs can only be estimated at the time the loan is approved. The Bank has sought to minimize its risk in construction lending and in lending for the purchase of raw land by offering such financing primarily to builders and developers to whom the Bank has loaned funds in the past and to persons who have previous experience in such projects. The Bank also limits construction lending and loans on raw land to its market area, with which management is familiar.

Adjustable-rate loans decrease the risks associated with changes in interest rates by periodically repricing, but involve other risks because as interest rates increase, the underlying payments by the borrower increase, thus increasing the potential for payment default. At the same time, the marketability of the underlying collateral may be adversely affected by higher interest rates. Upward adjustment of the contractual interest rate may also be limited by the maximum periodic interest rate adjustment permitted in certain adjustable-rate mortgage loan documents, and, therefore is potentially limited in effectiveness during periods of rapidly rising interest rates. These risks have not had an adverse effect on the Bank.

The Bank’s adjustable-rate loan portfolio includes approximately $4.0 million in loan participations indexed to the London Interbank Offered Rate (“LIBOR”) which is expected to be phased out by June 30, 2023. On December 16, 2022, the Board of Governors of the Federal Reserve System (Board) adopted Regulation ZZ to implement the Adjustable Interest Rate (LIBOR) Act (the “Act”). The Act was approved by Congress on March 15, 2022, to address references to LIBOR in contracts that are governed by US law; will not mature before June 30, 2023; and most importantly, will lack fallback provisions providing for a clearly defined practical replacement for LIBOR. The final rule replaces references to LIBOR in such contracts with one of five Board-selected benchmark replacements based on the Secured Overnight Financing Rate (“SOFR”), which may include spread adjustments specified in the Act. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities and published daily by the Federal Reserve Bank of New York. The final rule identifies Board-selected benchmark replacements for (1) derivative transactions, (2) Federal Housing Finance Agency (FHFA) regulated entity contracts, (3) Federal Family Education Loan Program (FFELP) asset-based securitizations (ABS), (4) consumer loans, and (5) all other LIBOR contracts for replacing the overnight and one-, three-, six-, and 12-month tenors of US dollar LIBOR in existing contracts that do not provide for use of a clearly defined or practical replacement benchmark rate. The Bank must rely on the lead bank to renegotiate the terms of loans in which the Bank has a participation. There can be no assurance that the lead bank will be able to successfully renegotiate the loans in which the Bank has participations or that the substitute reference rate will perform as satisfactorily as LIBOR.

Consumer lending, including indirect financing, provides benefits to the Bank’s asset/liability management program by reducing the Bank’s exposure to interest rate changes, due to their generally shorter terms. Such loans may entail additional credit risks compared to owner-occupied residential mortgage lending especially when unsecured or secured by collateral such as automobiles that depreciate rapidly.

Commercial lending including real-estate related loans entail significant additional risks when compared with residential real estate and consumer lending. For example, commercial loans typically involve larger loan balances to single borrowers or groups of related borrowers. The payment experience on such loans typically is dependent on the successful operation of the project and these risks can be significantly impacted by the cash flow of the borrowers and market conditions for commercial office, retail, and warehouse space. In periods of decreasing cash flows, the commercial borrower may permit a lapse in general maintenance of the property causing the value of the underlying collateral to deteriorate. The liquidation of commercial property is often more costly and may involve more time to sell than residential real estate. The Bank offsets such factors with requiring more owner equity, a lower loan to value ratio and

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by obtaining the personal guaranties of the principals. In addition, a majority of the Bank’s commercial real estate portfolio is owner-occupied property.

Commercial loans and leases are considered to have a higher degree of credit risk than secured real estate lending. The repayment of unsecured commercial business loans is wholly dependent on the success of the borrower’s business, while secured commercial business loans may be secured by collateral that may not be readily marketable in the event of default. Municipal financing includes lending to local taxing authorities and revenue-producing projects. Such loans may constitute the general obligation of the taxing authority or may rely on a specific revenue source which is responsible for the repayment of the debt. General obligations are considered to carry a lower level of risk than other loan types since they are backed by the full faith and credit of the taxing authority. Revenue obligations are backed solely by revenues generated by the project financed and repayment may be affected by the success of the project.

Due to the type and nature of the collateral, consumer lending generally involves more credit risk when compared with residential real estate lending. Consumer lending collections are typically dependent on the borrower’s continuing financial stability, and thus, are more likely to be adversely affected by job loss, divorce, illness and personal bankruptcy. In most cases, any repossessed collateral for a defaulted consumer loan will not provide an adequate source of repayment of the outstanding loan balance. The remaining deficiency is usually turned over to a collection agency.

There are additional risks associated with indirect lending since we must rely on the dealer to provide accurate information to us and accurate disclosures to the borrowers. These loans are principally done on a non-recourse basis. We seek to mitigate these risks by only dealing with dealers with whom we have a long-standing relationship.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) prohibits lenders from making residential mortgages unless the lender makes a reasonable and good faith determination that the borrower has a reasonable ability to repay the mortgage loan according to its terms. A borrower may recover statutory damages equal to all finance charges and fees paid within three years of a violation of the ability-to-repay rule and may raise a violation as a defense to foreclosure at any time. As authorized by the Dodd-Frank Act, the Consumer Financial Protection Bureau (“CFPB”) has adopted regulations defining “qualified mortgages” that are presumed to comply with the Dodd-Frank Act’s ability-to-repay rules. Under the CFPB regulations, qualified mortgages must satisfy the following criteria: (i) no negative amortization, interest-only payments, balloon payments, or term greater than 30 years; (ii) no points or fees in excess of 3% of the loan amount for loans over $100,000; (iii) borrower’s income and assets are verified and documented; and (iv) the borrower’s debt-to-income ratio generally may not exceed 43%. Qualified mortgages are conclusively presumed to comply with the ability-to-pay rule unless the mortgage is a “higher cost” mortgage, in which case the presumption is rebuttable. Under the Economic Growth, Regulatory Relief, and Consumer Protection Act, enacted in 2018, residential mortgages originated for portfolio by insured depository institutions, like the Bank, with less than $10 billion in total consolidated assets will be treated as qualified mortgages; provided that the mortgage terms do not include interest-only payments or negative amortization, total points and fees do not exceed 3% of the loan amount, prepayment penalties are not in excess of those permitted for qualified mortgages under Regulation Z and the lender has considered and documented the debt, income and financial resources of the borrower.

The Bank has established various lending limits for its officers and also maintains an Officer Loan Committee to approve higher loan amounts. The Officer Loan Committee is comprised of the President and Chief Executive Officer, Chief Lending Officer and other Bank officers. The Officer Loan Committee has the authority to approve all loans up to set limits based on the type of loan and the collateral. Requests in excess of these limits must be submitted to the Directors’ Loan Committee or Board of Directors for approval. Additionally, the President and Chief Executive Officer, and the Chief Lending Officer and other officers have the authority to approve secured and unsecured loans up to amounts approved by the Board of Directors and maintained in the Bank’s Loan Policy. Notwithstanding individual lending authority, certain loan policy exceptions must be submitted to the Officer Loan Committee for approval.

Hazard insurance coverage is required on all properties securing loans made by the Bank. Flood insurance is also required, when applicable.

Loan applicants are notified of the credit decision by letter. If the loan is approved, the loan commitment specifies the terms and conditions of the proposed loan including the amount, interest rate, amortization term, a brief description of the required collateral, and the required insurance coverage. The borrower must provide proof of fire, flood (if applicable) and casualty insurance on the property serving as collateral and title insurance, and these applicable insurances must be maintained during the full term of the loan.

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The following table sets forth maturities and interest rate sensitivity for selected categories of loans as of December 31, 2022. Scheduled repayments are reported in the maturity category in which payment is due. Demand loans, loans having no stated schedule of repayments and no stated maturity and overdrafts are reported as due in one year or less.

allowance for Loan Losses

The allowance for loan losses totaled $16,999,000 as of December 31, 2022 and represented 1.15% of total loans receivable compared to $16,442,000 and 1.21% of total loans as of year-end 2021. Net charge-offs for 2022 totaled $343,000 and represented 0.02% of average loans compared to $908,000 and 0.07% of average loans in 2021.

Management assesses the adequacy of the allowance for loan losses on a quarterly basis. The process includes a review of the risks inherent in the loan portfolio. It also includes an analysis of impaired loans and a historical review of losses. Other factors considered in the analysis include: concentrations of credit in specific industries in the commercial portfolio, the local and regional economic conditions, trends in delinquencies, internal risk rating classifications, total loan growth in the portfolio and fluctuations in large balance credits. For loans acquired, including those that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for credit losses for these loans is similar to originated loans; however, the Company records a provision for loan losses only when the required allowance exceeds any remaining credit discounts.

The Company has limited exposure to higher-risk loans. The Company does not originate option ARM products, interest only loans, sub-prime loans or loans with initial teaser rates in its residential real estate portfolio. As of December 31, 2022, the Company had $14,437,000 million of junior lien home equity loans. For the year ended December 31, 2022, there were $5,000 of charge-offs for this portfolio, with recoveries of $5,000 in 2022.

As of December 31, 2022, the Company considered its concentration of credit risk profile to be acceptable. The highest concentrations are in commercial rentals and the residential rentals categories.

At December 31, 2022, the recorded investment in impaired loans, not requiring an allowance for loan losses, was $413,000 (net of charge-offs against the allowance for loan losses of $0). The recorded investment in impaired loans, requiring an allowance for loan losses, was $50,000, (net of charge-offs against the allowance for loan losses of $0). At December 31, 2021, the recorded investment in impaired loans, not requiring an allowance for loan losses, was $157,000 (net of charge-offs of $0). The recorded investment in impaired loans, requiring an allowance for loan losses, was $1,517,000.

As a result of its analysis, after applying these factors, management considers the allowance as of December 31, 2022, adequate. However, there can be no assurance that the allowance for loan losses will be adequate to cover significant losses that might be incurred in the future.

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The following table sets forth information with respect to the Bank’s allowance for loan losses as of December 31, 2022 and 2021:

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The following table sets forth the allocation of the Bank’s allowance for loan losses by loan category and the percent of loans in each category to total loans at the date indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which credit losses may occur. The total allowance is available to absorb losses from any type of loan.

As a result of the acquisition of UpState, the Company added $107.3 million of agricultural loans to the loan portfolio. These loans are included in the outstanding balance information, but do not require an allocation of the allowance for loan losses since they were recorded at fair value in accordance with ASC 310-20 and ASC 310-30.

Additional information about the allowance for loan losses at December 31, 2022 is presented under “Item 1. Business” of this Annual Report on Form 10-K, as well as in Note 2 and Note 4 to the audited consolidated financial statements.

Non-Performing Assets

Non-performing assets consist of non-performing loans and real estate owned as a result of foreclosure, which is held for sale. Loans are placed on non-accrual status when management believes that a borrower’s financial condition is such that collection of interest is doubtful. Commercial and real estate related loans are generally placed on non-accrual when interest is 90 days delinquent. When loans are placed on non-accrual, unpaid interest credited to income in the current year is reversed and unpaid interest accrued in prior years is charged against the allowance for loan losses.

As of December 31, 2022, non-performing loans totaled $1,113,000 and represented 0.08% of total loans compared to $734,000 or 0.05% as of December 31, 2021. The increase in the level of non-performing loans was due primarily to one credit relationship in the amount of $452,000 that was transferred to non-accrual status in the fourth quarter of 2022.

Foreclosed real estate owned totaled $346,000 as of December 31, 2022 and $1,742,000 as of December 31, 2021. During 2022, one property with a carrying value of $1,396,000 was disposed of through a sale. The Company recorded a gain of $427,000 on the sale of the property during the year ended December 31, 2022.

Securities

The securities portfolio consists of U.S. Treasury securities, U.S. Government agencies, mortgage-backed securities issued by government sponsored entities and municipal obligations. The Company classifies its investments into two categories: held to maturity (HTM) and available for sale (AFS). The Company does not have trading securities. Securities classified as HTM are those in which the Company has the ability and the intent to hold the security until contractual maturity. As of December 31, 2022, there were no securities carried in the HTM portfolio. Securities classified as AFS are eligible to be sold due to liquidity needs or interest rate risk management. These securities are adjusted to and carried at their fair value with any unrealized gains or losses recorded net of deferred income taxes, as an adjustment to capital and reported in the equity section of the Consolidated Balance Sheet as other comprehensive income. As of December 31, 2022, $418.9 million of securities were so classified and carried at their fair value, with unrealized losses, net of tax, of $57.9 million included in accumulated other comprehensive income as a component of stockholders’ equity. The Company considers its investment portfolio a source of earnings and liquidity. Investment securities may also be pledged to secure public deposits and customer repurchase agreements.

As of December 31, 2022, the average life of the portfolio was 7.3 years. The Company has maintained a relatively short average life in the portfolio in order to generate cash flow to support loan growth and maintain liquidity levels. Purchases for the year

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totaled $130.8 million, while maturities and principal reductions totaled $40.8 million and proceeds from sales were $5.1 million. The purchases were funded principally by cash flow generated from the portfolio and excess overnight liquidity.

The following table sets forth certain information regarding securities not carried at fair value through earnings, weighted average yields, and maturities of the Company’s securities portfolio as of December 31, 2022 and 2021. Yields on tax-exempt securities are stated on a fully taxable equivalent basis using a Federal tax rate of 21%. Actual maturities may differ from contractual maturities as certain instruments have call features which allow prepayment of obligations. Maturity on the mortgage-backed securities is based upon contractual terms, the average life may differ as a result of changes in cash flow.

The portfolio had no adjustable-rate instruments as of December 31, 2022 and 2021. The portfolio contained no private label mortgage-backed securities, collateralized debt obligations (CDOs), or trust preferred securities, and no off-balance sheet derivatives were in use. As of December 31, 2022, the portfolio did not contain any step-up bonds. The mortgage-backed securities portfolio includes pass-through bonds and collateralized mortgage obligations (CMO’s) issued by Fannie Mae, Freddie Mac and the Government National Mortgage Association (GNMA).

The Company evaluates the securities in its portfolio for other-than-temporary-impairment (OTTI) as fair value declines below cost. In estimating OTTI, management considers (1) the length of time and the extent of the decline in fair value and (2) the financial condition and near-term prospects of the issuer. As of December 31, 2022, the Company held 343 investment securities in a loss position, which had a combined unrealized loss of $73.3 million. Management believes that these losses are principally due to changes in interest rates and represent temporary impairment as the Company does not have the intent to sell these securities and it is more likely than not that it will not have to sell the securities before recovery of their cost basis. No impairment charges were recognized in 2022 or 2021.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company uses fair value measurements to record fair value adjustments to certain financial instruments and determine fair value disclosures (see Note 16 of Notes to the Consolidated Financial Statements).

Approximately $420.4 million, which represents 20.5% of total assets at December 31, 2022, consisted of financial instruments recorded at fair value on a recurring basis. This amount consists entirely of the Company’s available for sale securities portfolio and interest rate derivatives. The Company uses valuation methodologies involving market-based or market-derived information, collectively Level 1 and 2 measurements, to measure fair value. There were no transfers into or out of Level 3 for any instruments for the years ended December 31, 2022 and 2021.

The Company utilizes a third party provider to perform valuations of the investments. Methods used to perform the valuations include: pricing models that vary based on asset class, available trade and bid information, actual transacted prices, and proprietary models for valuations of state and municipal obligations. In addition, the Company has a sample of fixed-income securities valued by another independent source. The Company does not adjust values received from its providers, unless it is evident that fair value measurement is not consistent with the Company’s policies.

The Company also utilizes a third party provider to provide the fair value of certain loan servicing rights. Fair value for the purpose of this measurement is defined as the amount at which the asset could be exchanged in a current transaction between willing

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parties, other than in a forced liquidation. The fair value of mortgage servicing rights as of December 31, 2022 and 2021 was $498,000 and $500,000, respectively.

DEPOSITS

The Bank provides a full range of deposit products to its retail and business customers. These include interest-bearing and noninterest bearing transaction accounts, statement savings and money market accounts. Certificate of deposit terms range up to five years for retail instruments. As of December 31, 2022, the Bank does not have any brokered deposits obtained through internet listing services, and no broker deposits which were secured through Cede & Co. The Bank participates in the Jumbo CD ($100,000 and over) markets with local municipalities and school districts which are typically priced on a competitive bid basis. Other services the Bank offers its customers include cash management, direct deposit, Remote Deposit Capture, mobile deposit capture, PopMoney® mobile payments and Automated Clearing House (ACH) activity. The Bank operates thirty automated teller machines and is affiliated with the MoneyPass® ATM network. Internet banking including bill-pay is offered through the website at www.waynebank.com. Other services, such as eStatements and mobile banking are available online.

The following table sets forth information regarding deposit categories of the Company.

As of December 31, 2022 and 2021, the total of uninsured deposits of the Company was $213,623,000 and $235,515,000, respectively. Total uninsured deposits is calculated based on regulatory reporting requirements and reflects the portion of any deposit of a customer at an insured depository institution that exceeds the applicable FDIC insurance coverage for that depositor at that institution and amounts in any other uninsured investment or deposit accounts that are classified as deposits and not subject to any federal or state deposit insurance regime.

As of December 31, 2022, the total of U.S. time deposits in excess of the Federal Deposit Insurance Corporation insurance limits were $213,623,000.

The following table indicates the amount of time deposits that are uninsured by time remaining until maturity as of December 31, 2022:

Total deposits as of December 31, 2022, were $1.728 billion, a decrease of $29.1 million from December 31, 2021. Non-maturity interest-bearing deposits increased $2.0 million in 2022, while non-interest bearing demand deposits decreased $6.1 million. Time deposits decreased $24.9 million during 2022.

Time deposits over $250,000, which consist principally of school district funds, other public funds and short-term deposits from large commercial customers with maturities generally less than one year, totaled $213.6 million as of December 31, 2022,

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compared to $257.2 million at year-end 2021. These deposits are subject to competitive bid and the Company bases its bid on current interest rates, loan demand, investment portfolio structure and the relative cost of other funding sources.

As of December 31, 2022, non-interest bearing demand deposits totaled $434.5 million compared to $440.7 million at December 31, 2021. Cash management accounts in the form of securities sold under agreements to repurchase included in short-term borrowings, totaled $51.0 million at December 31, 2022 compared to $60.8 million as of December 31, 2021. These balances represent commercial and municipal customers’ funds invested in overnight securities. The Company considers these accounts as a source of core funding.

RESULTS OF OPERATIONS

Summary

Net income for the Company for the year ended December 31, 2022 was $29,233,000, which was $4,318,000 higher than the $24,915,000 earned in 2021. Earnings per share on a fully diluted basis were $3.58 for 2022 compared to $3.04 in 2021. The return on average assets for the year ended December 31, 2022, was 1.43%, and the return on average equity was 16.11%, compared to 1.24% and 12.35%, respectively, for the year ended December 31, 2021. Net interest income increased $3,084,000 for the year ended December 31, 2022, which offset a $2,430,000 increase in other expenses during the 2022 year. A $3,300,000 decrease in the provision for loan losses, and a $1,571,000 increase in other income during the year ended December 31, 2022, also contributed to the positive variance.

For the year ended December 31, 2022, fully taxable equivalent (“fte”) net interest income totaled $69,164,000, which was an increase of $3,064,000 from the year ended 2021 total. Average loans outstanding increased $14.1 million in 2022, which resulted in an increase in interest income (fte) of $657,000. Total average securities increased $160.1 million in 2022 as proceeds from deposit growth and overnight liquidity were used to fund new purchases, resulting in a $3.6 million increase in total interest income (fte) on securities. During the year ended December 31, 2022, average interest-bearing deposits increased $67.4 million, resulting in a $1.7 million increase in total interest expense on deposits. The cost of borrowed funds decreased $202,000 in 2022, compared to the prior year due primarily to a lower level of borrowings. During the year ended December 31, 2022, the resulting net interest spread (fte) decreased one basis point to 3.38%, as a nine basis point increase in the yield earned was offset by a 10 basis point increase in the cost of funds.

Total other income for the year ended December 31, 2022 was $9,932,000, compared to $8,361,000 in the prior year, an increase of $1,571,000. During the year ended December 31, 2022, gains on the sale of loans and investment securities decreased $263,000 in the aggregate, while gains on the sale of foreclosed real estate owned increased $391,000. Service charges and fees decreased $32,000 in 2022 compared to the 2021, while all other items of other income increased $1,475,000, net, in 2022. The increase in 2022 includes $1.1 million of earnings recognized due to the payoff of purchased impaired loans acquired at a discount.

During the year ended December 31 ,2022, other expenses were $41,044,000, compared to $38,614,000 for the same period in 2021, an increase of $2,430,000. Salaries and benefits costs increased $1,463,000 in 2022, while occupancy and equipment costs rose $145,000. All other operating expenses increased $822,000, net, in 2022. Income tax expense for the 2022 year totaled $7,152,000, which was an increase of $1,207,000 from the 2021 year ended. The effective tax rate in 2022 was 19.7% compared to 19.3% in 2021. The increase in the effective tax rate reflects the increased level of taxable income, which is taxed at the marginal rate of 21%.

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The following table sets forth changes in net income (in thousands):

NET INTEREST INCOME

Net interest income is the most significant source of revenue for the Company and represented 87.3% of total revenue for the year ended December 31, 2022. Net interest income (fte) totaled $69,164,000 for the year ended December 31, 2022 compared to $66,100,000 for 2021, an increase of $3,064,000. The resulting fte net interest spread and net interest margin were 3.38% and 3.53%, respectively, in 2022 compared to 3.39% and 3.50%, respectively, in 2021.

Interest income (fte) for the year ended December 31, 2022 totaled $76,433,000 compared to $71,857,000 in 2021. The fte yield on average earning assets was 3.90%, increasing nine basis points from the 3.81% reported last year. The tax-equivalent yield on total loans remained stable at 4.73% in 2022, while average loans outstanding increased $14.1 million, resulting in an increase in interest income (fte) from loans of $657,000. The yield on securities increased 13 basis points in 2022 due primarily to higher yields on new purchases. During the 2022 year ended, average securities outstanding increased $160.1 million, as cash flows from deposit growth was utilized to fund new purchases, and interest income (fte) from the portfolio increased $3.6 million from the 2021 year ended.

Interest expense was $7,269,000 in 2022, which resulted in an average cost of interest-bearing liabilities of 0.52% compared to total interest expense of $5,757,000 in 2021, with an average cost of 0.42%. Total interest-bearing deposits cost was 0.49% in 2022, which was an increase of 11 basis points over the 2021 year. The increase in cost was due primarily to time certificates of deposit that repriced to current market rates upon maturity, resulting in an increase in the interest rate paid from 0.71% in 2021 to 0.97% in 2022. Borrowing costs also increased in 2022, reflecting the higher interest rate environment.

PROVISION FOR LOAN LOSSES

The provision for loan losses was $900,000 in 2022 compared to $4,200,000 in 2021. The decreased provision for loan losses recorded in 2022 reflects the removal of the qualitative factors specific to the COVID-19 pandemic. Qualitative factors specific to the pandemic that were developed in 2020 required a $2.3 million allocation to the required allowance for loan losses at December 31, 2021. Additionally, the quantitative factor related to historical loan losses decreased $670,000 compared to the 2021 level.

Management assesses the adequacy of the allowance for loan losses on a quarterly basis. The process includes a review of the risks inherent in the loan portfolio. It also includes an analysis of impaired loans and a historical review of losses. Other factors considered in the analysis include: concentrations of credit in specific industries in the commercial portfolio, the local and regional economic conditions, trends in delinquencies, internal risk rating classifications, total loan growth in the portfolio and fluctuations in large balance credits. For loans acquired, including those that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for credit losses for these loans is similar to originated loans; however, the Company records a provision for loan losses only when the required allowance exceeds any remaining credit discounts.

OTHER INCOME

Total other income was $9,932,000 for the year ended December 31, 2022, compared to $8,361,000 in 2021, an increase of $1,571,000. Debit card fees increased $267,000 in 2022, earnings and proceeds from bank-owned life insurance increased $146,000,

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and gains on the sale of foreclosed real estate owned increased $391,000. During 2022, gains on the sale of loans and investment securities decreased $263,000 in the aggregate, while all other items of other income increased $1,027,000, net.

Other Income (dollars in thousands)

For the year ended December 31

OTHER EXPENSES

Other expenses totaled $41,044,000 for the year ended December 31, 2022, compared to $38,614,000 in the 2021 year. Salaries and employee benefits costs increased $1,463,000 in 2022, while occupancy and equipment costs increased $145,000. During the year ended December 31, 2022, all other operating expenses increased $822,000, net. The Company’s efficiency ratio, which measures total other expenses as a percentage of net interest income (fte) plus other income, was 51.9% in 2022 compared to 51.8% in 2021.

Other Expenses (dollars in thousands)

For the year ended December 31

INCOME TAXES

Income tax expense for the year ended December 31, 2022 totaled $7,152,000, which resulted in an effective tax rate of 19.7%, compared to $5,945,000 and 19.3% for 2021. The higher effective tax rate reflects the increase in taxable income.

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CAPITAL AND DIVIDENDS

Total stockholders’ equity as of December 31, 2022, was $167.1 million, compared to $205.3 million as of December 31, 2021. Earnings retention, net of a $9.2 million reduction resulting from cash dividends declared, contributed to the increase. Fluctuations in interest rates during the year ended December 31, 2022, impacted the fair value of the Company’s Available-for-Sale securities, and contributed to $57.1 million decrease in capital as a reduction in accumulated other comprehensive income. As of December 31, 2022 the Company had a leverage capital ratio of 9.36%, a Tier 1 risk-based capital ratio and a common equity Tier 1 risk-based capital ratio of 12.49%, and a total risk-based capital ratio of 13.58%, compared to 8.51%, 12.49% and 13.66%, respectively, at December 31, 2021.

NON-GAAP FINANCIAL MEASURES

This Annual Report contains or references fully taxable-equivalent interest income and net interest income, which are non-GAAP financial measures. Tax-equivalent interest income and net interest income are derived from GAAP interest income and net interest income using a marginal tax rate of 21%. We believe the presentation of interest income and net interest income on a fully taxable-equivalent basis ensures comparability of interest income and net interest income arising from both taxable and tax-exempt sources and is consistent with industry practice.

The following table reconciles net interest income to net interest income on a fully taxable-equivalent basis:

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CONSOLIDATED AVERAGE BALANCE SHEETS WITH RESULTANT INTEREST AND RATES

(Tax-Equivalent Basis, dollars in thousands)

(1)Interest and yields are presented on a tax-equivalent basis using a marginal tax rate of 21%.

(2)Average balances have been calculated based on daily balances.

(3)Loan balances include non-accrual loans and are net of unearned income.

(4)Loan yields include the effect of amortization of purchased credit marks and deferred fees net of costs.

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RATE/VOLUME ANALYSIS

The following table shows the fully taxable equivalent effect of changes in volumes and rates on interest income and interest expense.

Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.