NORWOOD FINANCIAL CORP (NWFL) FY 2023 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, 2023 and 2022, and for the years ended December 31, 2023 and 2022. 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.

Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for credit losses and the determination of goodwill impairment. Please refer to the discussion of the allowance for credit losses calculation under “Allowance for Credit Losses and Non-performing Assets” in the “Financial Condition” section.

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, 2023 were $2.201 billion compared to $2.047 billion as of year-end 2022, an increase of $154.0 million. The increase in assets was primarily attributable to a $129.7 million increase in loans receivable.

Loans Receivable

As of December 31, 2023, loans receivable totaled $1.604 billion compared to $1.474 billion as of year-end 2022, an increase of $129.7 million due primarily to a $64.2 million increase in consumer loans. Commercial real estate loans increased $23.6 million, while construction loans increased $19.0 million during the year ended December 31, 2023.

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.

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.

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, 2023, there were $247.7 million of indirect loans in the portfolio.

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

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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 producing projects such as sewer authorities and educational units. At December 31, 2023, the Bank had approximately $149.2 million in loans on commercial rentals, as well as $115.2 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.

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 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.

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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.

The following table sets forth maturities and interest rate sensitivity for selected categories of loans as of December 31, 2023. 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.

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allowance for CREDIT Losses

The allowance for credit losses totaled $18,968,000 as of December 31, 2023, and represented 1.18% of total loans receivable compared to $16,999,000 and 1.15% of total loans as of year-end 2022. Net charge-offs for 2023 totaled $6,078,000 and represented 0.39% of average loans compared to $343,000 and 0.02% of average loans in 2022.

Management reviews the loan portfolio on a quarterly basis using a defined, consistently applied process in order to make appropriate and timely adjustments to the allowance for credit losses. When information confirms all or part of specific loans to be uncollectible, these amounts are promptly charged off against the allowance.

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, 2023, the Company had $16,805,000 million of junior lien home equity loans. For the year ended December 31, 2023, there were $0 of charge-offs for this portfolio, with recoveries of $0 in 2023.

Loan concentrations are considered to exist when there are amounts loaned to a number of borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. Our lending activity is heavily concentrated in the geographic market areas we serve. At December 31, 2023, the Company had no concentrations of loans in any one industry exceeding 10% of its total loan portfolio. An industry for this purpose is defined as a group of businesses that are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions.

As of December 31, 2023 and 2022, the Company considered its concentration of credit risk to be acceptable. As of December 31, 2023, the highest concentrations are in commercial rentals and the residential rentals category, with loans outstanding of $149.2 million, or 9.3% of loans outstanding, to commercial rentals, and $115.2 million, or 7.2% of loans outstanding, to residential rentals. For the year ended December 31, 2023, the Company recognized charge offs of $6,000 on commercial rentals and $44,000 on residential rentals. There were no charge-offs on loans within these concentrations in 2022.

Banking regulators have established guidelines of less than 100% of tier 1 capital plus allowance for credit losses in construction lending and less than 300% of tier 1 capital plus allowance for credit losses in commercial real estate lending that management monitors as part of the risk management process. The construction concentration ratio is a percentage of the outstanding construction and land development loans to total tier 1 capital plus allowance for credit losses. The commercial real estate concentration ratio is a percentage of the outstanding balance of non-owner occupied commercial real estate, multifamily, and construction and land development loans to tier 1 capital plus allowance for credit losses. Management strives to operate within the thresholds set forth above.

As of December 31, 2023, the Company had $675.2 million of commercial real estate loans, which represented 42.1% of total loans outstanding. Non-owner occupied commercial real estate loans totaled $294.9 million, or 18.4% of total loans outstanding and 134.8% of regulatory capital requirements. As of December 31, 2023, the Company had $51.5 million of construction loans, which represented 3.2% of total loans outstanding and 23.5% of regulatory capital requirements.

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The following table sets forth information with respect to the Bank’s allowance for credit losses as of December 31, 2023 and 2022:

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During the twelve month period ended December 31, 2023, the Bank recognized a charge-off in the amount of $4,806,000 on one commercial credit relationship resulting from the borrower’s inability to make scheduled contractual payments. This isolated event contributed to an increase in net charge-offs for the twelve months ended December 31, 2023 to $6,078,000 from the $343,000 of net charge-offs reported for the twelve months ended December 31, 2022. As of December 31, 2023, the remaining carrying value of the credit was $4,150,000, which was classified as a nonaccrual loan. As a result of this charge-off and transfer to nonperforming loans, the provision for credit losses increased to $5,548,000 for the twelve months ended December 31, 2023, compared to $900,000 for the twelve months ended December 31, 2022.

The following table sets forth the allocation of the Bank’s allowance for credit 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.

Additional information about the allowance for credit losses at December 31, 2023 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, 2023, non-performing loans totaled $7,622,000 and represented 0.48% of total loans compared to $1,113,000 or 0.08% as of December 31, 2022. The increase in the level of non-performing loans was due primarily to one commercial relationship in the amount of $6,956,000 that was transferred to non-accrual status in the third quarter of 2023. As of December 31, 2023, the carrying value of this credit was $4,150,000. In January 2024, a $3,900,000 payment was received through the sale of assets. The remaining $250,000 was reclassified to accounts receivable and is expected to be collected through contractual future payments.

Foreclosed real estate owned totaled $97,000 as of December 31, 2023 and $346,000 as of December 31, 2022. During 2023, one property with a carrying value of $346,000 was disposed of through a sale, after a partial write down of $54,000, and one property with a carrying value of $290,000 was disposed of through a sale. The Company recorded a gain of $80,000 on the sale of these two properties during the year ended December 31, 2023. Additionally, two properties with a carrying value of $387,000 were transferred to foreclosed real estate owned in 2023.

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, 2023, 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, 2023, $406.3 million of securities were so classified and carried at their fair value, with unrealized losses,

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net of tax, of $47.8 million included in accumulated other comprehensive income (loss) 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, 2023, the average life of the portfolio was 6.7 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 totaled $12.7 million, while maturities and principal reductions totaled $33.7 million and proceeds from sales were $3.3 million. The purchases were funded principally by cash flow generated from the portfolio.

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, 2023 and 2022. 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, 2023 and 2022. 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, 2023, 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 credit losses as fair value declines below cost. In estimating credit losses, management considers the financial condition and near-term prospects of the issuer. As of December 31, 2023, the Company held 336 investment securities in a loss position, which had a combined unrealized loss of $60.6 million. Management believes that these losses are principally due to changes in interest rates and concluded that the decline in the value of these securities was not indicative of a credit loss. The Company did not recognize any credit losses on the available-for-sale debt securities for the twelve months ended December 31, 2023, nor did they recognize any other-than- temporary-impairment charges for the twelve months ended December 31, 2022.

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 $407.5 million, which represents 18.5% of total assets at December 31, 2023, 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, 2023 and 2022.

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

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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 parties, other than in a forced liquidation. The fair value of mortgage servicing rights as of December 31, 2023 and 2022 was $506,000 and $498,000, 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, 2023, 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 IntraFi CDARS and ICS, cash management, direct deposit, Remote Deposit Capture, mobile deposit capture, Zelle 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, 2023 and 2022, the total of uninsured deposits of the Company was $644,486,000 and $629,101,000, 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, 2023, the total of U.S. time deposits in excess of the Federal Deposit Insurance Corporation insurance limits were $269,499,000.

The following table indicates the amount of time deposits that are uninsured by time remaining until maturity as of December 31, 2023:

Total deposits as of December 31, 2023, were $1.795 billion, an increase of $67.4 million from December 31, 2022. Non-maturity interest-bearing deposits decreased $102.9 million in 2023, while non-interest bearing demand deposits decreased $35.0 million. Time deposits increased $205.3 million during 2023.

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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 $241.8 million as of December 31, 2023, compared to $213.6 million at year-end 2022. 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, 2023, non-interest bearing demand deposits totaled $399.5 million compared to $434.5 million at December 31, 2022. Cash management accounts in the form of securities sold under agreements to repurchase included in short-term borrowings, totaled $54.1 million at December 31, 2023 compared to $51.0 million as of December 31, 2022. 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, 2023 was $16,759,000, which was $12,474,000 lower than the $29,233,000 earned in the year ended December 31, 2022. Earnings per share on a fully diluted basis were $2.07 for 2023 compared to $3.58 in 2022. The return on average assets for the year ended December 31, 2023, was 0.79%, and the return on average equity was 9.67%, compared to 1.43% and 16.11%, respectively, for the year ended December 31, 2022. Net interest income decreased $6,330,000 for the year ended December 31, 2023. The decrease in net income for the year ended December 31, 2023, is primarily attributable to a $4,648,000 increase in the provision for credit losses, a $1,808,000 decrease in other income, and a $2,453,000 increase in other expenses.

For the year ended December 31, 2023, fully taxable equivalent (“fte”) net interest income totaled $62,816,000, a decrease of $6,348,000 from the year ended December 31, 2022 total. Average loans outstanding increased $164.7 million in 2023, which contributed to an increase in interest income (fte) of $19.2 million. During the year ended December 31, 2023, average interest-bearing deposits decreased $441,000. During the year ended December 31, 2023, however, total interest expense increased $19.6 million due increased market interest rates. The cost of borrowed funds increased $6.6 million in 2023, compared to the prior year due to an increase in borrowings, and higher market interest rates. During the year ended December 31, 2023, the resulting net interest spread (fte) decreased to 2.47% compared to 3.38% at December 31, 2022, as a 0.78% increase in the yield earned was offset by a 1.69% increase in the cost of funds.

Total other income for the year ended December 31, 2023 was $8,124,000, compared to $9,932,000 in the prior year, a decrease of $1,808,000. During the year ended December 31, 2023, gains on the sale of loans and investment securities decreased $152,000 in the aggregate, while gains on the sale of foreclosed real estate owned decreased $347,000. Earnings and proceeds on life insurance policies decreased $75,000 in 2023 compared to 2022, while all other items of other income decreased $1,234,000, net, in 2023. The decrease in 2023 includes $1.1 million of earnings recognized in 2022 due to the payoff of purchased impaired loans acquired at a discount.

During the year ended December 31 ,2023, other expenses were $43,497,000, compared to $41,044,000 for the same period in 2022, an increase of $2,453,000. Salaries and benefits costs increased $1,494,000 in 2023, while data processing costs increased $394,000. Taxes, other than income decreased $447,000. All other operating expenses increased $1,012,000, net, in 2023. Income tax expense for the 2023 year totaled $4,387,000, which was a decrease of $2,765,000 from the 2022 year ended. The effective tax rate in 2023 was 20.7% compared to 19.7% in 2022.

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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 88.4% of total revenue for the year ended December 31, 2023. Net interest income (fte) totaled $62,816,000 for the year ended December 31, 2023 compared to $69,164,000 for 2022, an decrease of $6,348,000. The resulting fte net interest spread and net interest margin were 2.47% and 3.06%, respectively, in 2023 compared to 3.38% and 3.53%, respectively, in 2022.

Interest income (fte) for the year ended December 31, 2023 totaled $96,289,00 compared to $76,433,000 in 2022. The fte yield on average earning assets was 4.68%, increasing 78 basis points from the 3.90% reported last year. The tax-equivalent yield on total loans was 5.46% in 2023, increasing from 4.73% in 2022, while average loans outstanding increased $164.7 million, resulting in an increase in interest income (fte) from loans of $19.2 million. The yield on securities increased 17 basis points in 2023 due primarily to higher yields on new securities purchased during the year ended December 31, 2023. During the year ended December 31, 2023, while average securities outstanding decreased $1.4 million, interest income (fte) from securities outstanding, increased $803,000 from the year ended December 31, 2022.

Interest expense was $33,473,000 for the year ended December 31, 2023, which resulted in an average cost of interest-bearing liabilities of 2.21% compared to total interest expense of $7,269,000 during the year ended December 31, 2022, with an average cost of 0.52%. Total interest-bearing deposits cost was 1.96% for the year ended December 31, 2023, which was an increase of 147 basis points over the 2022 fiscal year ended. 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 0.97% in 2022 to 3.25% in 2023. Borrowing costs also increased in 2023, reflecting the higher market interest rate environment.

PROVISION FOR CREDIT LOSSES

The provision for credit losses was $5,548,000 in 2023 compared to $900,000 in 2022. During the twelve month period ended December 31, 2023, the Bank recognized a charge-off in the amount of $4,806,000 on one commercial credit relationship resulting from the borrower’s inability to make scheduled contractual payments. This isolated event contributed to an increase in net charge-offs for the twelve months ended December 31, 2023 to $6,078,000 from the $343,000 of net charge-offs reported for the twelve months ended December 31, 2022. As of December 31, 2023, the remaining carrying value of the credit was $4,150,000, which was classified as a nonaccrual loan.

The Company makes provisions for, or releases of, credit losses in an amount necessary to maintain the allowance for credit losses at an acceptable level under the current expected credit loss methodology analysis.

OTHER INCOME

Total other income was $8,124,000 for the year ended December 31, 2023, compared to $9,932,000 in 2022, a decrease of $1,808,000. Debit card fees decreased $194,000 in 2023, loan related service fees decreased $222,000, and gains on the sale of foreclosed real estate owned decreased $347,000. During 2023, gains on the sale of loans and investment securities decreased $152,000 in the aggregate, while all other items of other income decreased $893,000, net, due primarily to $1.1 million of income recognized in 2022 on previously acquired purchased impaired loans that were carried at a discount.

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Other Income (dollars in thousands)

For the year ended December 31

OTHER EXPENSES

Other expenses totaled $43,497,000 for the year ended December 31, 2023, compared to $41,044,000 in the 2022 fiscal year. Salaries and employee benefits costs increased $1,494,000 in 2023, while data processing costs increased $394,000. FDIC insurance assessments increased $373,000. During the year ended December 31, 2023, all other operating expenses increased $192,000, net. The Company’s efficiency ratio, which measures total other expenses as a percentage of net interest income (fte) plus other income, was 61.3% in 2023 compared to 51.9% in 2022.

Other Expenses (dollars in thousands)

For the year ended December 31

INCOME TAXES

Income tax expense for the year ended December 31, 2023 totaled $4,387,000, which resulted in an effective tax rate of 20.7%, compared to $7,152,000 and 19.7% for 2022.

CAPITAL AND DIVIDENDS

Total stockholders’ equity as of December 31, 2023, was $181.1 million, compared to $167.1 million as of December 31, 2022. Earnings retention, net of a $9.5 million reduction resulting from cash dividends declared, contributed to the increase. Fluctuations in interest rates during the year ended December 31, 2023, impacted the fair value of the Company’s Available-for-Sale securities, and contributed to $10.0 million increase in accumulated other comprehensive income. As of December 31, 2023 the Company had a leverage capital ratio of 9.00%, a Tier 1 risk-based capital ratio and a common equity Tier 1 risk-based capital ratio of 11.99%, and a total risk-based capital ratio of 13.06%, compared to 9.36%, 12.49% and 13.58%, respectively, at December 31, 2022.

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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.