EAGLE FINANCIAL SERVICES INC (EFSI) FY 2021 MD&A

Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operation

The purpose of this discussion is to focus on the important factors affecting the financial condition, results of operations, liquidity and capital resources of Eagle Financial Services, Inc. (the “Company”). This discussion should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of this Form 10-K.

GENERAL

The Company is a bank holding company which owns 100% of the stock of Bank of Clarke County (the “Bank”). Accordingly, the results of operations for the Company are dependent upon the operations of the Bank. The Bank conducts a commercial banking business which consists of attracting deposits from the general public and investing those funds in commercial, consumer and real estate loans and corporate, municipal and U.S. government agency securities. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation to the extent permitted by law. At December 31, 2021, the Company had total assets of $1.30 billion, net loans of $976.9 million, total deposits of $1.18 billion and shareholders’ equity of $110.3 million. The Company’s net income was $11.0 million for the year ended December 31, 2021.

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The following table presents selected financial data, which was derived from the Company’s audited financial statements for the periods indicated.

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COVID-19 AND RELATED RESPONSE

The COVID-19 crisis has changed our communities, both in the way we live and the way we do business. While

circumstances continue to change, the Company is continuing to work steadfastly to meet and exceed the needs of its customers, employees, and the communities in which it does business. Customers’ banking needs have continued to be fulfilled through multiple banking channels including mobile, digital, and adjusted-schedule physical. In efforts to assist local businesses during this pandemic, the Company originated 1,372 Paycheck Protection Program (“PPP”) loans (through two rounds of lending), totaling $132.1 million, into the hands of our community’s small businesses. As of December 31, 2021, $15.9 million in PPP loans were still outstanding. In addition to local small businesses, the Company worked with its consumer and commercial customers through its loan deferral program whereby customers experiencing hardships due to COVID-19 were granted a deferral in loan payments for up to 90 days. During 2020 and through the quarter ended March 31, 2021, the Company approved 256 deferrals with loan balances totaling approximately $127.5 million for its customers experiencing hardships related to COVID-19. As of December 31, 2021, all of these loans had begun making payments on their loans after the deferral date had passed.

MANAGEMENT’S STRATEGY

The Company strives to be an outstanding financial institution in its market by building solid sustainable relationships with: (1) its customers, by providing highly personalized customer service, a network of conveniently placed branches and ATMs, a competitive variety of products/services and courteous, professional employees, (2) its employees, by providing generous benefits, a positive work environment, advancement opportunities and incentives to exceed expectations, (3) its communities, by participating in local concerns, providing monetary support, supporting employee volunteerism and providing employment opportunities, and (4) its shareholders, by providing sound profits and returns, sustainable growth, regular dividends and committing to our local, independent status.

OPERATING STRATEGY

The Bank is a locally owned and managed financial institution. This allows the Bank to be flexible and responsive in the products and services it offers. The Bank grows primarily by lending funds to local residents and businesses at a competitive price that reflects the inherent risk of lending. The Bank attempts to fund these loans through deposits gathered from local residents and businesses. The Bank prices its deposits by comparing alternative sources of funds and selecting the lowest cost available. When deposits are not adequate to fund asset growth, the Bank relies on borrowings, both short and long term. The Bank’s primary source of borrowed funds is the Federal Home Loan Bank of Atlanta which offers numerous terms and rate structures to the Bank.

As interest rates change, the Bank attempts to maintain its net interest margin. This is accomplished by changing the price, terms, and mix of its financial assets and liabilities. The Bank also earns fees on services provided through Eagle Investment Group, which is the Bank’s investment management division that offers both trust services and investment sales, mortgage originations and deposit operations. The Bank also incurs noninterest expenses associated with compensating employees, maintaining and acquiring fixed assets, and purchasing goods and services necessary to support its daily operations.

The Bank has a marketing department which seeks to develop new business. This is accomplished through an ongoing calling program whereby account officers visit with existing and potential customers to discuss the products and services offered. The Bank also utilizes traditional advertising such as television commercials, radio ads, newspaper ads, and billboards.

LENDING POLICIES

Administration and supervision over the lending process is provided by the Bank’s Credit Administration Department. The principal risk associated with the Bank’s loan portfolio is the creditworthiness of its borrowers. In an effort to manage this risk, the Bank’s policy gives loan amount approval limits to individual loan officers based on their position and level of experience. Credit risk is increased or decreased, depending on the type of loan and prevailing economic conditions. In consideration of the different types of loans in the portfolio, the risk associated with real estate mortgage loans, commercial loans and consumer loans varies based on employment levels, consumer confidence, fluctuations in the value of real estate and other conditions that affect the ability of borrowers to repay debt.

The Company has written policies and procedures to help manage credit risk. The Company utilizes a loan review process that includes formulation of portfolio management strategy, guidelines for underwriting standards and risk assessment, procedures for ongoing identification and management of credit deterioration, and regular portfolio reviews to establish loss exposure and to ascertain compliance with the Company’s policies.

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The Bank uses a tiered approach to approve credit requests consisting of individual lending authorities, joint approval of Co-Approval officers (Executive, Regional Credit Officer, Small Business Credit Officer), and a director loan committee. Lending limits for individuals are set by the Board of Directors and are determined by loan purpose, collateral type, and internal risk rating of the borrower. The highest individual authority (Executive) is assigned to the Bank’s President/ Chief Executive Officer, Chief Banking Officer and Chief Credit Officer (approval authority only). Two Executive officers may combine their authority to approve loan requests to borrowers with credit exposure up to $10.0 million on a secured basis and $6.0 million unsecured. Three Executive officers may combine to approve loan requests to borrowers with credit exposure up to $15.0 million on a secured basis and $9.0 million unsecured. Officers in Categories A through F have lesser authorities and with approval of an Executive officer may extend loans to borrowers with exposure of $5.0 million on a secured basis and $3.0 million unsecured.  Officers in Categories A through F can also utilize the co-approval of the Regional and Small Business Credit Officers to extend loans with exposures up to $2.5 million and $1.5 million respectively on a secured basis, and up to $1 million and $750 thousand respectively on an unsecured basis.  Loans exceeding $15.0 million and up to the Bank’s legal lending limit can be approved by the Director Loan Committee consisting of four directors (three directors constituting a quorum). The Director’s Loan Committee also reviews and approves changes to the Bank’s Loan Policy as presented by management. The following sections discuss the major loan categories within the total loan portfolio:

One-to-Four-Family Residential Real Estate Lending

Residential lending activity may be generated by the Bank’s loan officer solicitations, referrals by real estate professionals, and existing or new bank customers. Loan applications are taken by a Bank loan officer. As part of the application process, information is gathered concerning income, employment and credit history of the applicant. The valuation of residential collateral is provided by independent fee appraisers who have been approved by the Bank’s Directors Loan Committee. In connection with residential real estate loans, the Bank requires title insurance, hazard insurance and, if applicable, flood insurance. In addition to traditional residential mortgage loans secured by a first or junior lien on the property, the Bank offers home equity lines of credit.

Commercial Real Estate Lending

Commercial real estate loans are secured by various types of commercial real estate in the Bank’s market area, including multi-family residential buildings, commercial buildings and offices, small shopping centers and churches. Commercial real estate loan originations are obtained through broker referrals, direct solicitation of developers and continued business from customers. In its underwriting of commercial real estate, the Bank’s loan to original appraised value ratio is generally 80% or less. Commercial real estate lending entails significant additional risk as compared with residential mortgage lending. Commercial real estate loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. Additionally, the repayment of loans secured by income producing properties is typically dependent on the successful operation of a business or a real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, in general. The Bank’s commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness, prior credit history and reputation, and the Bank typically requires personal guarantees or endorsements of the borrowers’ principal owners.

Construction and Land Development Lending

The Bank makes local construction loans and land acquisition and development loans. The construction loans are secured by residential houses under construction and the underlying land for which the loan was obtained. The average life of most construction loans is less than one year and the Bank offers both fixed and variable rate interest structures. The interest rate structure offered to customers depends on the total amount of these loans outstanding and the impact of the interest rate structure on the Bank’s overall interest rate risk. There are two characteristics of construction lending which impact its overall risk as compared to residential mortgage lending. First, there is more concentration risk due to the extension of a large loan balance through several lines of credit to a single developer or contractor. Second, there is more collateral risk due to the fact that loan funds are provided to the borrower based upon the estimated value of the collateral after completion. This could cause an inaccurate estimate of the amount needed to complete construction or an excessive loan-to-value ratio. To mitigate the risks associated with construction lending, the Bank generally limits loan amounts to 80% of the estimated appraised value of the finished property. The Bank also obtains a first lien on the property as security for its construction loans and typically requires personal guarantees from the borrower’s principal owners. Finally, the Bank performs inspections of the construction projects to ensure that the percentage of construction completed correlates with the amount of draws on the construction line of credit.

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Commercial and Industrial Lending

Commercial business loans generally have more risk than residential mortgage loans but have higher yields. To manage these risks, the Bank generally obtains appropriate collateral and personal guarantees from the borrower’s principal owners and monitors the financial condition of its business borrowers. Residential mortgage loans generally are made on the basis of the borrower’s ability to make repayment from employment and other income and are secured by real estate whose value tends to be readily ascertainable. In contrast, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from cash flow from its business and are secured by business assets, such as, accounts receivable, equipment and inventory. As a result, the availability of funds for the repayment of commercial business loans is substantially dependent on the success of the business itself. Furthermore, the collateral for commercial business loans may depreciate over time and generally cannot be appraised with as much precision as residential real estate. Refer to the Marine Lending section below for discussion of additional commercial and industrial lending.

Consumer Lending

The Bank offers various secured and unsecured consumer loans, which include personal installment loans, personal lines of credit, automobile loans, and credit card loans. The Bank generally originates its consumer loans within its geographic market area and these loans are largely made to customers with whom the Bank has an existing relationship. Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciable assets such as automobiles. In such cases, any repossessed collateral on a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

The underwriting standards employed by the Bank for consumer loans include a determination of the applicant’s payment history on other debts and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment, and from any verifiable secondary income. Although creditworthiness of the applicant is the primary consideration, the underwriting process also includes an analysis of the value of the security in relation to the proposed loan amount.

Refer to the Marine Lending section below for discussion of additional consumer lending.

Marine Lending

The Bank’s marine lending unit, which includes originated retail loans, which are classified as commercial and industrial loans or consumer loans depending on borrower, and dealer floorplan loans, which are classified as commercial and industrial loans. The Company’s relationships are limited to well established dealers of global premium brand manufacturers. The Company’s top three manufacturer customers have been in business between 30 and 100 years. The Company primarily has secured agreements with premium manufacturers to support dealer floor plan loans which reduces the Company’s credit exposure to the dealer, despite its underwriting of each respective dealer. The Company has developed incentive retail pricing programs with the dealers to drive retail dealer flow. In addition to the repurchase agreements associated with floor plan lending, manufacturers will often support secondary resale values which can have the effect of reducing losses from non-performing retail marine loans. Retail borrowers generally have very high credit scores, substantial down payments, substantial net worth, personal liquidity, and excess cash flow.

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CRITICAL ACCOUNTING POLICIES

The financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The financial information contained within these statements is, to a significant extent, based on measurements of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of the transactions would be the same, the timing of events that would impact the transactions could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the probable losses inherent in the Company’s loan portfolio. As required by GAAP, the allowance for loan losses is accrued when the occurrence of losses is probable and losses can be estimated.  Impairment losses are accrued based on the differences between the loan balance and the value of its collateral, the present value of future cash flows, or the price established in the secondary market. The Company’s allowance for loan losses has three basic components: the general allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when actual events occur. The general allowance uses historical experience and other qualitative factors to estimate future losses and, as a result, the estimated amount of losses can differ significantly from the actual amount of losses which would be incurred in the future. However, the potential for significant differences is mitigated by continuously updating the loss history and qualitative factor analyses of the Company. The specific allowance is based upon the evaluation of specific impaired loans on which a loss may be realized. Factors such as past due history, ability to pay, and collateral value are used to identify those loans on which a loss may be realized. Each of these loans is then evaluated to determine how much loss is estimated to be realized on its disposition. The sum of the losses on the individual loans becomes the Company’s specific allowance. This process is inherently subjective and actual losses may be greater than or less than the estimated specific allowance. The unallocated allowance accounts for a measure of imprecision in the estimate. Note 1 to the Consolidated Financial Statements presented in Item 8, Financial Statements and Supplementary Data, of the 2021 Form 10-K, provides additional information related to the allowance for loan losses.

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FORWARD LOOKING STATEMENTS

The Company makes forward looking statements in this report that are subject to risks and uncertainties. These forward looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward looking statements. These forward looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

Because of these uncertainties, actual future results may be materially different from the results indicated by these forward looking statements. In addition, past results of operations do not necessarily indicate future results.

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RESULTS OF OPERATIONS

Net Income

Net income for 2021 was $11.0 million, a decrease of $151 thousand or 1.35% from 2020’s net income of $11.2 million. Basic and diluted earnings per share were $3.20 and $3.27 for 2021 and 2020, respectively.

Return on average assets (“ROA”) measures how efficiently the Company uses its assets to produce net income. Some issues reflected within this efficiency include the Company’s asset mix, funding sources, pricing, fee generation, and cost control. The ROA of the Company, on an annualized basis, was 0.90% and 1.11% for 2021 and 2020, respectively.

Return on average equity (“ROE”) measures the utilization of shareholders’ equity in generating net income. This measurement is affected by the same factors as ROA with consideration to how much of the Company’s assets are funded by the shareholders. The ROE for the Company was 10.28% and 11.03% for 2021 and 2020, respectively.

Net Interest Income

Net interest income, the difference between total interest income and total interest expense, is the Company’s primary source of earnings. Net interest income was $41.0 million for 2021 and $35.6 million for 2020, which represents an increase of $5.4 million or 15.08%. Net interest income is derived from the volume of earning assets and the rates earned on those assets as compared to the cost of funds. Total interest income was $42.7 million for 2021 and for $38.9 million 2020, which represents an increase of $3.8 million or 9.68% for 2021. Total interest expense was $1.7 million for 2021 and $3.3 million for 2020, which represents a decrease of $1.6 million or 48.89% in 2021. The increase in total interest income and net interest income during 2021 was driven by the growth in interest-earning assets and the continued lower level of rates paid on deposit accounts driven by the market. Refer to the table titled “Volume and Rate Analysis” for further detail.

The table titled “Average Balances, Income and Expenses, Yields and Rates” displays the composition of interest earnings assets and interest bearing liabilities and their respective yields and rates for the years ended December 31, 2021 and 2020.

The net interest margin was 3.60% for 2021 and 3.76% for 2020. The net interest margin is calculated by dividing tax-equivalent net interest income by total average earnings assets. Tax-equivalent net interest income is calculated by adding the tax benefit on certain securities and loans, whose interest is tax-exempt, to total interest income then subtracting total interest expense. The tax rate used to calculate the tax benefit was the federal statutory rate of 21%. The table titled “Tax-Equivalent Net Interest Income” reconciles net interest income to tax-equivalent net interest income, which is not a measurement under GAAP, for the years ended December 31, 2021 and 2020.

Net interest income and net interest margin may experience some additional decline as interest bearing assets continue to be repriced or replaced more rapidly than interest earning liabilities.

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Average Balances, Income and Expenses, Yields and Rates

(dollars in thousands)

(2)   Interest and yields on loans include the amortization/accretion of origination costs/fees as well as any purchase premiums or discounts.

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Tax-Equivalent Net Interest Income

(dollars in thousands)

The tax-equivalent yield on earning assets decreased 35 basis points from 2020 to 2021. The tax-equivalent yield on securities decreased 82 basis points from 2020 to 2021. The tax-equivalent yield on loans decreased 53 basis points from 2020 to 2021. The decrease in the tax-equivalent yield on earning assets for the resulted mostly from the decrease in the tax-equivalent yield on loans. The decrease in the yield on loans as compared to the corresponding period in the prior year was primarily due to SBA PPP loans that were originated at a lower yield than the existing portfolio as well as rate decreases during early 2020. Additionally, as securities are maturing and being called or sold, they are being replaced with securities at lower rates.

The average rate on interest-bearing liabilities decreased 33 basis points from 2020 to 2021. The average rate on total interest-bearing deposits decreased 33 basis points from 2020 to 2021. Federal Reserve Bank interest rate decreases during early 2020 drove a reduction in interest rates paid on deposit accounts, which resulted in a lower rate paid on interest bearing liabilities. In general, deposit pricing is done in response to monetary policy actions and yield curve changes. Local competition for funds affects the cost of time deposits, which are primarily comprised of certificates of deposit. The Company prefers to rely most heavily on non-maturity deposits, which include NOW accounts, money market accounts, and savings accounts. The average balance of non-maturity interest-bearing deposits increased $112.6 million or 27.08% from $415.9 million during 2020 to $528.5 million in 2021.

The table titled “Volume and Rate Analysis” provides information about the effect of changes in financial assets and liabilities and changes in rates on net interest income. Non-accruing loans are excluded from the average outstanding loans.

Tax-equivalent net interest income increased $5.3 million during 2021. The increase in tax-equivalent net interest income during 2021 is comprised of an increase due to volume of $5.5 million and a decrease due to rate of $189 thousand. The increase in tax-equivalent net interest income during 2021 was affected by the increased volume of taxable loans and taxable securities, offset in part by decreases in the rates earned from interest-earning assets.

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Volume and Rate Analysis (Tax-Equivalent Basis)

(dollars in thousands)

Provision for Loan Losses

The provision for loan losses is based upon management’s estimate of the amount required to maintain an adequate allowance for loan losses as discussed within the Critical Accounting Policies section above. The provision for loan losses was $1.5 million for 2021 and $1.5 million for 2020. The amount of provision for loan losses during each period reflects the results of the Company’s analysis used to determine the adequacy of the allowance for loan losses. The provision for loan losses in 2021 reflects loan growth in the portfolio during the year. The provision for loan losses in 2020 reflects loan growth in the portfolio during the year as well as decline in the state of the economy and the related increase in the qualitative factors within our allowance for loan losses, primarily associated with the COVID-19 pandemic. The Company is committed to maintaining an allowance that adequately reflects the risk inherent in the loan portfolio.  This commitment is more fully discussed in the “Asset Quality” section.

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Noninterest Income

Total noninterest income was $11.3 million and $8.6 million during 2021 and 2020, respectively. This represents an increase of $2.7 million or 31.95% for 2021. Management reviews the activities which generate noninterest income on an ongoing basis.

The following table provides the components of noninterest income for the twelve months ended December 31, 2021 and 2020, which are included within the respective Consolidated Statements of Income headings.  The following paragraphs provide information about activities which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

NM - Not Meaningful

Income from fiduciary activities increased from 2020 to 2021. The amount of income from fiduciary activities is

determined by the number of active accounts and total assets under management. With the addition of several new employees, total assets under management have seen an increase during the period.

Services charges on deposit accounts increased when comparing the year ended December 31, 2021 to 2020. This increase is mainly due to increases in overdraft charges. Overdraft charges can fluctuate based on changes in customer activity.

The amount of other services charges and fees is comprised primarily of commissions from the sale of non-deposit investment products, fees received from the Bank’s credit card program, fees generated from the Bank’s ATM/debit card programs, and fees generated from procuring applications for secondary market loans. Other service charges and fees increased during 2021 when compared to 2020. This increase can be attributed to an increase in ATM fees, which fluctuates due to ATM usage. Commissions from the sale of non-deposit investment products increased $248 thousand during 2021 due to increased activity.

During the last three quarters of 2021, the Company sold $18.1 million in mortgage loans on the secondary market and $99.2 million of loans from the commercial and consumer loan portfolios. These loan sales resulted in gains of $1.7 million during the year ended December 31, 2021.

Bank owned life insurance (BOLI) income increased significantly during 2021 when compared to 2020. During 2021 the Company invested $10 million into BOLI.

Other operating income increased during 2021.  The fluctuation from 2020 to 2021 is mostly attributed to adjustments to the investment in Banker’s Insurance as well as cash distributions received from investments in Small Business Investment Companies (SBICs)

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Noninterest Expenses

Total noninterest expenses were $38.0 million and $29.4 million during 2021 and 2020, respectively. This represents an increase of $8.6 million or 29.24% during 2021.

The following table provides the components of noninterest expense for the twelve months ended December 31, 2021 and 2020, which are included within the respective Consolidated Statements of Income headings.  The following paragraphs provide information about activities which are included within the respective Consolidated Statements of Income headings. Variances that the Company believes require explanation are discussed below the table.

NM  - Not Meaningful

The Company’s growth has had an impact on noninterest expenses. Total assets have grown by $172.9 million or 15.3% from December 31, 2020 to December 31, 2021. This growth has required investments to be made in the Company’s infrastructure, causing increases in salaries and employee benefits, occupancy expenses, stationary and supplies, computer software expense, professional fees and other operating expenses. In addition, increases in asset size and capital levels have impacted both the FDIC assessment and bank franchise tax amounts.

Salaries and employee benefits expense increased during 2021. Annual pay increases, newly hired employees, increasing insurance costs and enhanced employee incentive plans have attributed to these increases. The number of full-time equivalent employees (FTEs) has increased from 195 at December 31, 2020 to 221 at December 31, 2021.

ATM network fees increased during 2021 due to increased ATM usage. During the height of the COVID-19 pandemic in 2020, customer activity and usage decreased. During 2021, increases in customer activity have been observed.

Other real estate owned expenses increased during 2021. These amounts can fluctuate based on the number of properties foreclosed on and sold during any time period.

Professional fees increased during 2021. Included within processional fees, legal expenses have increased primarily from the expansion of the Bank's wealth management business line and also its build out of the marine lending division. Approximately $2.0 million of these expenses are expected to be one-time fees.

Other operating expenses increased during 2021.This increase is due primarily to increased loan related expenses due to a higher loan volume.

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The efficiency ratio of the Company was 72.14% and 67.59% for 2021 and 2020, respectively. The efficiency ratio is calculated by dividing total noninterest expenses by the sum of tax-equivalent net interest income and total noninterest income, excluding gains and losses on the investment portfolio and other gains/losses from OREO, repossessed vehicles, disposals of bank premises and equipment, etc. The tax rate utilized is 21%. The Company calculates and reviews this ratio as a means of evaluating operational efficiency. A reconciliation of tax-equivalent net interest income, which is not a measurement under GAAP, to net interest income is presented within the Net Interest Income section above.

The calculation of the efficiency ratio for the twelve months ended December 31, 2021 and 2020 are as follows:

Income Taxes

Income tax expense was $1.8 million and $2.1 million for the years ended December 31, 2021 and 2020, respectively. These amounts correspond to an effective tax rate of 13.81% and 16.05% for 2021 and 2020, respectively. The effective tax rate is below the statutory rate of 21%, due primarily to tax credits on qualified affordable housing project investments as discussed in Note 25 to the Consolidated Financial Statements as well as qualified rehabilitation credits. During 2021, one of the Company’s tax credit investments was finalized and the total amount of credits to be received was determined and certified.  The effective tax rate is also impacted by tax-exempt income on investment securities and loans. Note 9 to the Consolidated Financial Statements provides a reconciliation between income tax expense computed using the federal statutory income tax rate and the Company’s actual income tax expense during 2021 and 2020.

FINANCIAL CONDITION

Assets, Liabilities and Shareholders’ Equity

The Company’s total assets were $1.30 billion at December 31, 2021, an increase of $172.9 million or  15.30% from $1.13 billion at December 31, 2020. Securities increased $27.4 million or 16.59% between 2020 and 2021. Loans, net of the allowance for loan losses, increased by $147.7 million or 17.81% from 2020 to 2021. Total liabilities were $1.19 billion at December 31, 2021, compared to $1.03 billion at December 31, 2020. Total shareholders’ equity at year end 2021 and 2020 was $110.3 million and $105.1 million, respectively.

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Securities

Total securities, excluding restricted stock, was $192.3 million and $165.0 million for the years ended December 31, 2021 and December 31, 2020, respectively. The Company purchased $100.8 million in securities during 2021. This amount includes $97.6 million or 96.77% in mortgage-backed securities, $2.0 million or 1.99% in U.S. treasuries and $1.3 million or 1.24% in subordinated debt.  The Company had $52.0 million in maturities, calls, and principal repayments on securities during 2021. This amount includes $2.0 million or 3.87% in obligations of U.S. government corporations and agencies, $45.3 million or $87.06% in mortgage-backed securities and $4.7 million or 9.07% in obligations of states and political subdivisions. Note 2 to the Consolidated Financial Statements provides additional details about the Company’s securities portfolio as of December 31, 2021 and 2020.

The ability to dispose of available for sale securities prior to maturity provides management more options to react to future rate changes and provides more liquidity, when needed, to meet short-term obligations. The Company had a net unrealized loss on available for sale securities of $218 thousand and an unrealized net gain of $4.1 million at December 31, 2021 and 2020, respectively. Unrealized gains or losses on available for sale securities are reported within shareholders’ equity, net of the related deferred tax effect, as accumulated other comprehensive income (loss).

The table titled “Maturity Distribution and Yields of Securities” shows the maturity period and average yield for the different types of securities in the portfolio at December 31, 2021. The weighted average yield is calculated based on the relative amortized costs of the securities. Although mortgage-backed securities have definitive maturities, they provide monthly principal curtailments which can be reinvested at a prevailing rate and for a different term.

Maturity Distribution and Yields of Securities

(dollars in thousands)

Loan Portfolio

The Company’s primary use of funds is supporting lending activities from which it derives the greatest amount of interest income. Gross loans net of net deferred costs and premiums were $985.7 million and $836.3 million at December 31, 2021 and 2020, respectively. This represents an increase of $149.4 million or 17.86% for 2021. The ratio of net loans to deposits increased during the year from 81.85% to 82.99% at December 31, 2020 and December 31, 2021, respectively.

Loans secured by real estate were $754.8 million or 76.57% and $662.8 million or 79.25% of total loans at December 31, 2021 and 2020, respectively. This represents an increase of $92.0 million or 13.88% for 2021. Consumer installment loans were $67.3 million or 6.83% and $21.3 million or 2.55% of total loans at December 31, 2021 and 2020, respectively. This represents an increase of $46.0 million or 215.56% for 2021. Commercial and industrial loans were $143.4 million or 14.55% and $140.8 million or 16.83% of total loans at December 31, 2021 and 2020. This represents an increase of $2.6 million or 1.86% for 2021. All other loans were $16.8 million and $10.8 million at December 31, 2021 and 2020. This represents an increase of $6.0 million or 55.93%. During the year ended December 31, 2021, loan growth was mainly concentrated in commercial real estate loans and consumer installment loans. Loan growth was also strong in commercial and industrial loans net of PPP forgiveness. Loan growth in commercial and industrial loans and consumer installment loans was mainly due to the marine loan lending.  Loan growth was also driven by the expansion into new market areas.

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The table titled “Maturity Schedule of Selected Loans” shows the different loan categories and the period during which they mature. For loans maturing in more than one year, the table also shows a breakdown between fixed rate loans and floating rate loans. The table indicates that $369.4 million or 37.61% of the loan portfolio matures within five years. The floating rate loans maturing after five years are primarily comprised of loan secured by 1-4 family residential properties.

Maturity Schedule of Selected Loans

(dollars in thousands)

Asset Quality

The Company has policies and procedures designed to control credit risk and to maintain the quality of its loan portfolio. These include underwriting standards for new originations and ongoing monitoring and reporting of asset quality and adequacy of the allowance for loan losses. There were $2.8 million in total non-performing assets, which consist of nonaccrual loans, loans 90 days or more past due and still accruing, other real estate owned, and repossessed assets at December 31, 2021. This is a decrease of $2.6 million when compared to the December 31, 2020 balance of $5.4 million. This decrease resulted mostly from the decrease in nonaccrual loans.

Nonaccrual loans were $2.7 million at December 31, 2021 and $4.8 million at the end of 2020. The gross amount of interest income that would have been recognized on nonaccrual loans was $133 thousand for 2021 and $158 thousand for 2020. None of this interest income was included in net income for 2021 or 2020.  A total of 8 loans totaling $589 thousand were placed in nonaccrual during 2021. The balance of these loans added to nonaccrual status during 2021 ranged from $10 thousand to $221 thousand with the average outstanding balance being $74 thousand.  In addition, 14 loans totaling $1.9 million were removed from nonaccrual status during 2021.  Of the $1.9 million in loans removed from nonaccrual status between December 31, 2020 and December 31, 2021, 10 loans were paid off, one loan was foreclosed on and three loans were returned to accrual status. The remainder of the decrease in nonaccrual loans was due to paydowns of loans that remained in nonaccrual status between December 31, 2020 and December 31, 2021. Management evaluates the financial condition of these borrowers and the value of any collateral on these loans. The results of these evaluations are used to estimate the amount of losses which may be realized on the disposition of these nonaccrual loans. Nonaccrual loans that were evaluated for impairment at December 31, 2021 totaled $2.7 million and had $8 thousand in specific allocations assigned.

Other real estate owned decreased from $607 thousand at December 31, 2020 to zero at December 31, 2021.  Two properties were foreclosed on and five properties were sold during 2021. The difference between the amount of other real estate owned and the settlement proceeds is recognized as a gain or loss on the sale of other real estate owned. A net loss of $201 thousand was recognized on other real estate owned during 2021. A net gain of $143 thousand was recognized on other real estate owned during 2020.

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Nonperforming and Other Assets

Nonperforming assets consist of nonaccrual loans, loans past due 90 days and accruing interest, other real estate owned (foreclosed properties), and repossessed assets. The table titled “Nonperforming Assets and Credit Ratios” shows the amount of nonperforming assets and loans past due 90 days and accruing interest outstanding for the past two years. The table also shows the ratios for the allowance for loan losses as a percentage of nonperforming assets and nonperforming assets as a percentage of loans outstanding and other real estate owned.

Loans are placed on non-accrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due. There are three negative implications for earnings when a loan is placed on non-accrual status. First, all interest accrued but unpaid at the date that the loan is placed on non-accrual status is either deducted from interest income or written off as a loss. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. Finally, there may be actual losses that require additional provisions for loan losses to be charged against earnings.

For real estate loans, upon foreclosure, the properties are recorded at the fair value of the property based on current appraisals and other current market trends, less selling costs. If a write down of the OREO property is necessary at the time of foreclosure, the amount is charged-off against the allowance for loan losses. A review of the recorded property value is performed in conjunction with normal loan reviews, and if market conditions indicate that the recorded value exceeds the fair value, additional write downs of the property value are charged directly to operations. Gains on properties acquired through foreclosure where the fair value less costs to sell exceeds the related loan balance and there have been no prior charge-offs are recorded to current earnings.

In addition, the Company may, under certain circumstances, restructure loans in troubled debt restructurings as a concession to a borrower when the borrower is experiencing financial distress. Each loan considered for restructuring is evaluated based on customer circumstances and may include modifications to one or more loan provisions. Such restructured loans are included in impaired loans. At December 31, 2021 and 2020, the Company had $2.7 million and $3.3 million in restructured loans, respectively.

Nonperforming Assets and Credit Ratios

(dollars in thousands)

Other potential problem loans are defined as performing loans that possess certain risks that management has identified that could result in the loans not being repaid in accordance with their terms. Accordingly, these loans are risk rated at a level of substandard or lower. At December 31, 2021, other potential problem loans totaled $2.1 million. Of the total other potential problem loans, $2.1 million or 100.00% are currently considered impaired and are disclosed in Note 4 to the Consolidated Financial Statements.

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Allowance for Loan Losses

The purpose and the methods for measuring the allowance for loans are discussed in the Critical Accounting Policies section above.

Charged-off loans were $110 thousand and $465 thousand for 2021 and 2020, respectively. Recoveries were $318 thousand and $1.1 million for 2021 and 2020, respectively. Net recoveries were $208 thousand for 2021. Net recoveries were $666 thousand for 2020. This represents a decrease in net recoveries of $458 thousand or 69% for 2021. The allowance for loan losses as a percentage of loans was 0.89% and 0.85% at the end of 2021 and 2020, respectively. Excluding outstanding PPP loans of $15.9 million and $81.3 million as of December 31, 2021 and 2020, respectively, the allowance for loan losses as a percentage of total loans was 0.91% and 0.94% as of December 31, 2021 and 2020, respectively. The increase in allowance for loan losses as a percentage of total loans from December 31, 2020 to December 31, 2021 was primarily due to loan growth in pools of the portfolio that require a higher general allocation percentage due to the level of inherent risk. The ratio of net charge-offs (recoveries) to average loans was (0.02%) for 2021 and (0.09%) for 2020.

The provision for loan losses for the years ended December 31, 2021 and 2020 was $1.5 million. The provision for loan losses in 2021 reflected mainly loan growth in the portfolio. The provision for loan losses in 2020 reflected loan growth in the portfolio during the year as well as decline in the state of the economy and the related increase in the qualitative factors within our allowance for loan losses, primarily associated with the COVID-19 pandemic. In addition, during 2020, the provision for loan losses was reduced as a result of net recoveries of $666 thousand.

The table titled “Allocation of Allowance for Loan Losses” shows the amount of the allowance for loan losses which is allocated to the indicated loan categories, along with that category’s percentage of total loans, at December 31, 2021 and 2020. The amount of allowance for loan losses allocated to each loan category is based on the amount of delinquent loans in that loan category, the status of nonperforming assets in that loan category, the historical losses for that loan category, the evaluation of qualitative factors impacting the portfolio and the financial condition of certain borrowers whose financial conditional is monitored on a periodic basis. Management believes that the allowance for loan losses is adequate based on the loan portfolio’s current risk characteristics.

Analysis of Allowance for Loan Losses

(dollars in thousands)

Allocation of Allowance for Loan Losses

(dollars in thousands)

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Deposits

Total deposits were $1.18 billion and $1.01 billion at December 31, 2021 and 2020, respectively, which represents an increase of $164.1 million or 16.20% during 2021. The table titled “Average Deposits and Rates Paid” shows the average deposit balances and average rates paid for 2021 and 2020.

Average Deposits and Rates Paid

(dollars in thousands)

Noninterest-bearing demand deposits, which are comprised of checking accounts, increased $62.8 million or 15.40% from $407.6 million at December 31, 2020 to $470.4 million at December 31, 2021. Interest-bearing deposits, which include NOW accounts, money market accounts, regular savings accounts and time deposits, increased $101.4 million or 16.74% from $605.5 million at December 31, 2020 to $706.9 million at December 31, 2021. Total money market account balances increased $44.0 million or 21.18% from $207.8 million at December 31, 2020 to $251.9 million at December 31, 2021. Reciprocal deposit accounts balances (included in total money market account and NOW account balances) increased from $34.6 million to $42.2 million at December 31, 2020 and December 31, 2021, respectively. The reciprocal deposits balance at December 31, 2021 and December 31, 2020 consists of money market and NOW accounts obtained through the ICS network. Total regular savings account balances increased $32.0 million or 23.37% from $136.8 million at December 31, 2020 to $168.7 million at December 31, 2021. The growth in deposits was mainly organic growth as we expand and

grow into newer market areas. Time deposits decreased $5.1 million or 3.94% from $128.7 million at December 31, 2020 to $123.6 million at December 31, 2021. Total estimated uninsured deposits at December 31, 2021 and 2020 were $356.3 million and $300.0 million, respectively.

The Company attempts to fund asset growth with deposit accounts and focus upon core deposit growth as its primary source of funding. Core deposits consist of checking accounts, NOW accounts, money market accounts, regular savings accounts, and time deposits of less than $250,000. Core deposits totaled $1.11 billion or 94.47% and $944.0 million or 93.19% of total deposits at December 31, 2021 and 2020, respectively.

The table titled “Maturities of Certificates of Deposit and Other Time Deposits of $250,000 and Greater” shows the amount of certificates of deposit of $250,000 and more maturing within the time periods indicated at December 31, 2021. The total amount maturing within one year is $60.8 million or 93.29% of the total amount outstanding.

Maturities of Certificates of Deposit and Other Time Deposits of $250,000 and Greater

(dollars in thousands)

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The table titled “Certificates of Deposit and Other Time Deposits Otherwise Uninsured shows the amount of certificates of deposit are in excess of the FDIC insurance limit at December 31, 2021. The total amount maturing within one year is $54.3 million or 94.97% of the total amount outstanding.

Certificates of Deposit and Other Time Deposits Otherwise Uninsured

(dollars in thousands)

CAPITAL RESOURCES

Total shareholders’ equity on December 31, 2021 was $110.3 million, reflecting a percentage of total assets of 8.46% as compared to $105.1 million and 9.30% at December 31, 2020. The common stock’s book value per share increased $0.88 or 2.83% to $31.93 per share at December 31, 2021 from $31.05 per share at December 31, 2020. During 2021, the Company paid $1.10 per share in dividends as compared to $1.04 per share for 2020. The Company has a Dividend Investment Plan that allows participating shareholders to reinvest the dividends in Company stock. During 2021, the Company purchased 4,749 shares of its Common Stock under its stock repurchase program at an average price of $31.26.  During 2020, the Company purchased 67,189 shares of its Common Stock under its stock repurchase program at an average price of $27.60.  As evidenced below, the Bank continues to be a well capitalized financial institution.

Analysis of Bank Capital

(dollars in thousands)

Federal regulatory risk-based capital guidelines require percentages to be applied to various assets, including off-balance sheet assets, based on their perceived risk in order to calculate risk-weighted assets. Tier 1 capital consists of total shareholders’ equity plus qualifying trust preferred securities outstanding less net unrealized gains and losses on available for sale securities, goodwill and other intangible assets. Total capital is comprised of Tier 1 capital plus the allowable portion of the allowance for loan losses and any excess trust preferred securities that do not qualify as Tier 1 capital.

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Effective January 1, 2015, the Federal Reserve issued final risk-based capital rules to align with the Basel III regulatory capital framework and meet certain requirements of the Dodd-Frank Act. The final rules require the Bank to comply with the following minimum capital ratios: (i) a common equity Tier 1 capital ratio of 4.5% of risk-weighted assets; (ii) a Tier 1 capital ratio of 6.0% of risk-weighted assets; (iii) a total capital ratio of 8.0% of risk-weighted assets; and (iv) a leverage ratio of 4.0% of total assets. In addition, a capital conservation buffer requirement was phased in beginning January 1, 2016, at 0.625% of risk-weighted assets, increased by the same amount each year until it was fully implemented at 2.5% effective January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with any ratio (excluding the leverage ratio) above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall. As fully phased in effective January 1, 2019, the rules require the Bank to maintain (i) a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% common equity Tier 1 ratio, effectively resulting in a minimum ratio of common equity Tier 1 to risk-weighted assets of at least 7.0%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio, effectively resulting in a minimum Tier 1 capital ratio of 8.5%), (iii) a minimum ratio of total capital to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio, effectively resulting in a minimum total capital ratio of 10.5%), and (iv) a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to average assets.

Pursuant to the Federal Reserve’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement, qualifying bank holding companies with total consolidated assets of less than $3 billion, such as the Company, is not subject to consolidated regulatory capital requirements.

The table titled “Analysis of Bank Capital” shows the components of Tier 1 capital, Tier 2 capital, the amount of total risk-based capital and risk-weighted assets, and the risk based capital ratios for the Bank at December 31, 2021 and 2020.

On September 17, 2019, the Federal Deposit Insurance Corporation finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio “CBLR” framework), as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework. In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9 percent, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. On April 6, 2020, in a joint statement, the FDIC, Federal Reserve and the Office of Comptroller of the Currency (“OCC”), issued two interim final rules regarding temporary changes to the CBLR framework to implement provisions of the CARES Act. Under the interim final rules, the community bank leverage ratio will be reduced to 8 percent beginning in the second quarter and for the remainder of calendar year 2020, 8.5 percent for calendar year 2021, and 9 percent thereafter. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk based capital. The CBLR framework was first available for banks to use beginning in their March 31, 2020, Call Report. The Bank opted into the CBLR framework as of December 31, 2021.

Note 15 to the Consolidated Financial Statements provides additional discussion and analysis of regulatory capital requirements.

LIQUIDITY

Liquidity management involves meeting the present and future financial obligations of the Company with the sale or maturity of assets or with the occurrence of additional liabilities. Liquidity needs are met with cash on hand, deposits in banks, federal funds sold, securities classified as available for sale and loans maturing within one year. At December 31, 2021 liquid assets totaled $365.1 million as compared to $320.4 million at December 31, 2020. These amounts represent 30.61% and 31.26% of total liabilities at December 31, 2021 and 2020, respectively. Securities provide a constant source of liquidity through paydowns and maturities. Also, the Company maintains short-term borrowing arrangements, namely federal funds lines of credit, with larger financial institutions as an additional source of liquidity. The Bank’s membership with the Federal Home Loan Bank of Atlanta also provides a source of borrowings with numerous rate and term structures. The Company’s senior management monitors the liquidity position regularly and attempts to maintain a position which utilizes available funds most efficiently. As a result of the Company’s management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors’ requirements and meet its customers’ credit needs.

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OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS

Note 18 to the Consolidated Financial Statements provides information about the off-balance sheet arrangements which arise through the lending activities of the Company. These arrangements increase the degree of both credit and interest rate risk beyond that which is recognized through the financial assets and liabilities on the consolidated balance sheets.

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