FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington D.C. 20549 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2003 Commission File No. 0-20050 PRINCETON NATIONAL BANCORP, INC. (Exact name of registrant as specified in its charter) Delaware 36-32110283 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 606 S. Main Street, Princeton, IL 61356 (Address of principal executive offices and Zip Code) (815) 875-4444 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _X_ No ___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ___ No _X_ As of April 23, 2003, the registrant had outstanding 3,201,457 shares of its $5 par value common stock. Page 1 of 20 pages PART I: FINANCIAL INFORMATION The unaudited consolidated financial statements of Princeton National Bancorp, Inc. and Subsidiary and management's discussion and analysis of financial condition and results of operations are presented in the schedules as follows: Schedule 1: Consolidated Balance Sheets Schedule 2: Consolidated Statements of Income and Comprehensive Income Schedule 3: Consolidated Statements of Stockholders' Equity Schedule 4: Consolidated Statements of Cash Flows Schedule 5: Notes to Consolidated Financial Statements Schedule 6: Management's Discussion and Analysis of Financial Condition and Results of Operations Schedule 7: Controls and Procedures PART II: OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 99.1 Certification of Tony J. Sorcic 99.2 Certification of Todd D. Fanning (b) No reports on Form 8-K were filed by the Corporation for the quarter ended March 31, 2003. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PRINCETON NATIONAL BANCORP, INC. Date: May 12, 2003 By /s/ Tony J. Sorcic ----------------------------------- Tony J. Sorcic President & Chief Executive Officer Date: May 12, 2003 By /s/ Todd D. Fanning ----------------------------------- Todd D. Fanning Vice-President & Chief Financial Officer 2 CERTIFICATIONS I, Tony J. Sorcic, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Princeton National Bancorp, Inc; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition , results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiary, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: 5-12-03 /s/ Tony J. Sorcic President & CEO -------------------- ------------------------------- Signature-Title 3 I, Todd D. Fanning, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Princeton National Bancorp, Inc; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition , results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiary, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: 5-12-03 /s/ Todd D. Fanning, Vice President & CFO ------------------ ---------------------------------------- Signature-Title 4 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY Schedule 1 CONSOLIDATED BALANCE SHEETS (Unaudited) (dollars in thousands, except share data MARCH 31, December 31, 2003 2002 --------- --------- ASSETS Cash and due from banks $ 14,641 $ 13,939 Interest-bearing deposits with financial institutions 10,158 1,706 Federal funds sold 12,040 3,225 --------- --------- Total cash and cash equivalents 36,839 18,870 Loans held for sale, at lower of cost or market 2,766 6,761 Investment securities: Available-for-sale, at fair value 151,534 157,881 Held-to-maturity, at amortized cost 13,731 11,437 --------- --------- Total investment securities 165,265 169,318 --------- --------- Loans: Loans, net of unearned interest 358,946 357,359 Allowance for loan losses (2,546) (2,660) --------- --------- Net loans 356,400 354,699 --------- --------- Premises and equipment, net of accumulated depreciation 13,203 13,388 Bank-owned life insurance 13,691 13,566 Interest receivable 3,929 5,180 Goodwill, net of accumulated amortization 1,355 1,355 Intangible assets, net of accumulated amortization 1,681 1,732 Other real estate owned 94 75 Other assets 2,377 2,431 --------- --------- TOTAL ASSETS $ 597,600 $ 587,375 ========= ========= LIABILITIES Deposits: Demand $ 57,336 $ 58,655 Interest-bearing demand 162,326 155,549 Savings 55,932 51,750 Time 249,572 245,313 --------- --------- Total deposits 525,166 511,267 Borrowings: Customer repurchase agreements 8,048 10,044 Advances from the Federal Home Loan Bank 5,600 5,750 Interest-bearing demand notes issued to the U.S. Treasury 736 2,397 Note payable 1,300 1,300 --------- --------- Total borrowings 15,684 19,491 Other liabilities 5,399 5,543 --------- --------- TOTAL LIABILITIES 546,249 536,301 --------- --------- STOCKHOLDERS' EQUITY Common stock: $5 par value, 7,000,000 shares authorized; 4,139,841 issued 20,699 20,699 Surplus 6,727 6,612 Retained earnings 36,471 35,255 Accumulated other comprehensive income, net of tax 1,991 2,218 Less: Cost of 938,384 and 906,155 treasury shares at March 31, 2003 and December 31, 2002, respectively (14,537) (13,710) --------- --------- TOTAL STOCKHOLDERS' EQUITY 51,351 51,074 --------- --------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 597,600 $ 587,375 ========= ========= SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY Schedule 2 CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA) For the Three Months Ended March 31, 2003 2002 ---------- ---------- INTEREST INCOME: Interest and fees on loans $ 5,984 $ 6,281 Interest and dividends on investment securities 1,804 1,911 Interest on federal funds sold 20 35 Interest on interest-bearing time deposits in other banks 16 25 ---------- ---------- Total interest income 7,824 8,252 INTEREST EXPENSE: Interest on deposits 2,770 3,448 Interest on borrowings 108 143 ---------- ---------- Total interest expense 2,878 3,591 ---------- ---------- NET INTEREST INCOME 4,946 4,661 Provision for loan losses 100 225 ---------- ---------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 4,846 4,436 NON-INTEREST INCOME: Trust & farm management fees 322 303 Service charges on deposit accounts 722 671 Other service charges 133 165 Gain on sales of securities available-for-sale 0 40 Brokerage fee income 131 179 Mortgage banking income 633 271 Bank-owned life insurance income 150 163 Other operating income 72 101 ---------- ---------- Total non-interest income 2,163 1,893 NON-INTEREST EXPENSE: Salaries and employee benefits 2,571 2,441 Occupancy 307 298 Equipment expense 396 356 Federal insurance assessments 55 53 Intangible assets amortization 52 52 Data processing 179 184 Other real estate owned expenses 8 0 Other operating expense 960 851 ---------- ---------- Total non-interest expense 4,528 4,235 ---------- ---------- INCOME BEFORE INCOME TAXES 2,481 2,094 Income tax expense 709 576 ---------- ---------- NET INCOME $ 1,772 $ 1,518 ========== ========== NET INCOME PER SHARE: Basic 0.55 0.46 Diluted 0.55 0.46 Basic weighted average shares outstanding 3,221,291 3,304,440 Diluted weighted average shares outstanding 3,250,428 3,317,809 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY Schedule 2 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) (DOLLARS IN THOUSANDS) For the Three Months Ended March 31 2003 2002 ------- ------- Net Income $ 1,772 $ 1,518 Other comprehensive income (loss), net of tax Unrealized holding loss arising during the period (227) (693) Less: Reclassification adjustment for realized gains included in net income 0 (25) ------- ------- Other comprehensive income loss (227) (718) ------- ------- Comprehensive income $ 1,545 $ 800 ======= ======= SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY Schedule 3 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (UNAUDITED) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) For the Three Months Ended March 31 2003 2002 -------- -------- Balance, January 1 $ 51,074 $ 47,500 Net income 1,772 1,518 Cash dividends ($0.15 per share in 2003, and $.13 per share in 2002) (485) (429) Other comprehensive loss, net of tax (227) (718) Purchases of treasury stock (40,000 shares in 2003, and 0 shares in 2002) (878) 0 Exercise of stock options and re-issuance of treasury stock (7,085 shares in 2003 and 444 shares in 2002) 81 2 Sales of treasury stock (686 shares in 2003, and 1,028 shares in 2002) 14 16 -------- -------- Balance, March 31 $ 51,351 $ 47,889 ======== ======== SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY Schedule 4 CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (DOLLARS IN THOUSANDS) For the Three Months Ended March 31 2003 2002 -------- -------- OPERATING ACTIVITIES: Net income $ 1,772 $ 1,518 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 353 298 Provision for loan losses 100 225 Amortization of other intangible assets 52 52 Amortization of premiums on investment securities, net of accretion 421 158 Gain on securities transactions, net 0 (40) Gain on sale of premises and equipment (2) 0 FHLB stock dividends (22) (24) Loans originated for sale (18,077) (7,706) Proceeds from sales of loans originated for sale 22,072 10,481 Decrease in interest payable (285) (541) Decrease in interest receivable 1,251 1,165 Increase in other assets (91) (230) Increase in other liabilities 285 276 -------- -------- NET CASH PROVIDED BY OPERATING ACTIVITIES 7,829 5,632 -------- -------- INVESTING ACTIVITIES: Proceeds from sales of investment securities available-for-sale 0 1,308 Proceeds from maturities of investment securities available-for-sale 10,701 11,993 Purchase of investment securities available-for-sale (8,188) (17,920) Proceeds from maturities of investment securities held-to-maturity 770 1,079 Purchase of investment securities held-to-maturity 0 (437) Proceeds from sales of premises and equipment 2 0 Net increase in loans (1,801) (4,779) Purchases of premises and equipment (168) (218) -------- -------- NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 1,316 (8,974) -------- -------- FINANCING ACTIVITIES: Net increase (decrease) in deposits 13,899 (5,082) Net (decrease) increase in borrowings (3,807) 755 Dividends paid (485) (429) Purchases of treasury stock (878) 0 Exercise stock options 81 2 Sales of treasury stock 14 16 -------- -------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 8,824 (4,738) -------- -------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 17,969 (8,080) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 18,870 33,726 -------- -------- CASH AND CASH EQUIVALENTS AT MARCH 31 $ 36,839 $ 25,646 ======== ======== -------------------------------------------------------------------------------------------------- Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 3,163 $ 4,132 Income taxes $ 105 $ 125 Supplemental disclosures of non-cash flow activities: Loans transferred to other real estate owned $ 27 $ 0 SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9 Schedule 5 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY Notes to Consolidated Financial Statements (Unaudited) The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information required by accounting principles generally accepted in the United States of America for complete financial statements and related footnote disclosures. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered for a fair presentation of the results for the interim period have been included. For further information, refer to the consolidated financial statements and notes included in the Registrant's 2002 Annual Report on Form 10-K. Results of operations for interim periods are not necessarily indicative of the results that may be expected for the year. Certain amounts in the 2002 consolidated financial statements have been reclassified to conform to the 2003 presentation. (1) EARNINGS PER SHARE CALCULATION The following table sets forth the computation of basic and diluted earnings per share for the periods indicated (in thousands, except share data): Three Months Ended March 31, 2003 2002 ---------- ----------- Numerator: Net income $ 1,772 $ 1,518 Denominator: Basic earnings per share- weighted average shares 3,221,291 3,304,440 Effect of dilutive securities- stock options 29,137 13,369 ---------- ----------- Diluted earnings per share- adjusted weighted average shares 3,250,428 3,317,809 Net income per share: Basic $ 0.55 $ 0.46 Diluted $ 0.55 $ 0.46 10 (2) GOODWILL AND INTANGIBLE ASSETS ---------------------------------- The balance of goodwill, net of accumulated amortization, totaled $1,355,000 at March 31, 2003 and December 31, 2002. The balance of intangible assets, net of accumulated amortization, totaled $1,681,000 and $1,732,000 at March 31, 2003 and December 31, 2002, respectively. The following table summarizes the Corporation's intangible assets, which are subject to amortization, as of March 31, 2003 and December 31, 2002. 2003 2002 ---- ---- Gross Carrying Accumulated Gross Carrying Accumulated Amount Amortization Amount Amortization -------------- ------------ -------------- ------------ Core deposit intangible $ 2,968 $ (1,352) $ 2,968 $ (1,303) Other intangible assets 160 (95) 160 (93) -------- --------- -------- --------- Total $ 3,128 $ (1,447) $ 3,128 $ (1,396) ======== ========= ======== ========= Amortization expense totaled $52,000 both for the first quarter of 2003 and 2002, respectively. The amortization expense will be approximately $156,000 for the remainder of 2003 and will be approximately $205,000 for each of the next five years. The Corporation's other intangible assets consist of originated mortgage servicing rights which are included in other assets on the consolidated balance sheets. Mortgage servicing rights are amortized in proportion to, and over the period of, estimated net servicing income similar to the interest method using an accelerated amortization method and are subject to periodic impairment testing. As of March 31, 2003 no impairment had been recorded. Changes in the carrying value of capitalized mortgage servicing rights are summarized as follows: (in thousands) Balance, January 1 $ 970 Servicing rights capitalized 208 Amortization of servicing rights (89) Impairment of servicing rights 0 -------- Balance, March 31 $ 1,089 ======== Amortization expense for the mortgage servicing rights asset are based on assumptions made during each reporting period. Such assumptions include, but are not limited to, the current level of interest rates and the forecasted prepayment speeds. Actual amortization expense is also affected by the amount of loans sold with servicing retained. 11 The following table shows the future estimated amortization expense for mortgage servicing rights based on existing balances as of March 31, 2003. The Corporation's actual amortization expense in any given period may be significantly different from the estimated amounts displayed depending on the amount of additional servicing rights, changes in mortgage interest rates, estimated prepayment speeds, and market conditions. ESTIMATED AMORTIZATION EXPENSE: Amount (in thousands) --------------------- For the nine months ended December 31, 2003 $ 245 For the year ended December 31, 2004 268 For the year ended December 31, 2005 206 For the year ended December 31, 2006 153 For the year ended December 31, 2007 104 For the year ended December 31, 2008 61 Thereafter 52 (3) STOCK OPTION PLAN --------------------- The Corporation accounts for the stock-based compensation plan under APB Opinion No. 25. For the stock option program, no compensation cost is recognized in connection with the granting of stock options with an exercise price equal to the fair market value of the stock on the date of the grant. In accordance with the disclosure requirements of FAS 123, as amended by FAS 148, the following table provides the pro forma effect on net income and earnings per share if the fair value method of accounting for stock-based compensation had been used for all awards: For the Three Months Ended March 31, ------------------------------------ (in thousands, except per share data) 2003 2002 ---- ---- Income as reported $ 1,772 $ 1,518 Deduct: Stock-based compensation, net of tax, that would have been reported if the fair value based method had been applied to all awards (60) (30) ------- ------- Pro forma net income $ 1,712 $ 1,488 ======= ======= Basic Earnings Per Share As Reported $ 0.55 $ 0.46 Pro Forma 0.53 0.45 Diluted Earnings Per Share As Reported $ 0.55 $ 0.46 Pro Forma 0.53 0.45 12 Schedule 6 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002 The following discussion provides information about Princeton National Bancorp, Inc.'s ("PNBC" or the "Corporation") financial condition and results of operations for the three months ended March 31, 2003 and 2002. This discussion should be read in conjunction with the attached consolidated financial statements and notes thereto. Certain statements in this report constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, but not limited to those statements that include the words "believes", "expects", "anticipates", "estimates", or similar expressions. PNBC cautions that such forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those expressed or implied. Such risks and uncertainties include potential change in interest rates, competitive factors in the financial services industry, general economic conditions, the effect of new legislation, and other risks detailed in documents filed by the Corporation with the Securities and Exchange Commission from time to time. RESULTS OF OPERATIONS --------------------- Net income for the first quarter of 2003 was $1,772,000, or basic and diluted earnings per share of $0.55, as compared to net income of $1,518,000 in the first quarter of 2002, or basic and diluted earnings per share of $0.46. This represents an increase of $254,000 (16.7%) or $.09 per basic and diluted share (19.6%). The increase in net income for the first three months of 2003 is a result of an increase in net interest income and increased non-interest income, partially offset by an increase in non-interest expense. The annualized return on average assets and return on average equity were 1.22% and 14.14%, respectively, for the first quarter of 2003, compared with 1.12% and 12.87% for the first quarter of 2002. Net interest income before provision for loan losses was $4,946,000 for the first quarter of 2003, compared to $4,661,000 for the first quarter of 2002 (an increase of $285,000 or 6.1%). This increase is a result of an increase in average interest-earning assets, offsetting a decrease in the net interest margin. The net yield on interest-earning assets (on a fully taxable equivalent basis) decreased from 4.06% in the first quarter of 2002 to 3.97% in the first quarter of 2003. However, for the three months ended March 31, 2003, average interest-earning assets were $538.6 million compared to $497.0 million for the three months ended March 31, 2002, an increase of $41.6 million (or 8.4%). PNBC recorded a loan loss provision of $100,000 in the first quarter of 2003 compared to $225,000 in the first quarter of 2002. The provision expense recorded each quarter is determined by the risk characteristics of the loan portfolio, as well as the net charge-off activity for the quarter. For the three-month comparable periods, PNBC had net charge-offs of $214,000 in 2003 and $91,000 in 2002. Non-interest income totaled $2,163,000 for the first quarter of 2003, as compared to $1,893,000 during 13 the first quarter of 2002, an increase of $270,000 (or 14.3%). This is a result of an increase in mortgage banking income of $362,000 (or 133.6%) due to fee income generated from continued origination/refinancing and subsequent sales and servicing of mortgage loans in the secondary market. Additionally, service charges on deposit accounts increased by $51,000 in the first quarter of 2003, an improvement of 7.6% over the first quarter of 2002. Income from trust and farm management also reported a modest increase of 6.3% (or $19,000) when comparing the first quarter of 2003 to the first quarter of 2002. These increases more than offset a decrease in gains from sales of securities available-for-sale of $40,000, as well as decreases in brokerage fee income ($48,000 or 26.9%) and other service charges ($32,000 or 19.4%). Total non-interest expense for the first quarter of 2003 was $4,528,000, an increase of $293,000 (or 6.9%) from $4,235,000 in the first quarter of 2002. The largest increases was in salaries/employee benefits, which increased $130,000 (or 5.3%) due to increases in commissions from mortgage banking operations as well as increased insurance costs. Other notable increases were in other operating expenses, which increased $109,000 (or 12.8%) due to a variety of small increases and in equipment expense, which increased $40,000 (11.2%) due to increased depreciation from the upgrade of bank technology. Additionally impacting other operating expense was the Corporation's decision to outsource the internal audit function. Given the continued growth of the organization and the current focus on corporate accounting procedures, PNBC believes this decision adds value to the organization, while also reducing salaries/employee benefits expense. INCOME TAXES ------------ Income tax expense totaled $709,000 for the first quarter of 2003, as compared to $576,000 for the first quarter of 2002. The effective tax rate was 28.6% for the three months ended March 31, 2003 compared to 27.5% for the three months ended March 31, 2002. ANALYSIS OF FINANCIAL CONDITION ------------------------------- Total assets at March 31, 2003 increased to $597,600,000 from $587,375,000 at December 31, 2002 (an increase of $10.2 million or 1.7%). Total deposits at March 31, 2003 increased to $525,166,000 from $511,267,000 at December 31, 2002 (an increase of $13.9 million or 2.7%). As interest rates have decreased over the past year, there continues to be a shift to savings and interest-bearing demand deposits (which would include money market and NOW accounts) and less of an increase in time deposits. Comparing categories of deposits at March 31, 2003 to the December 31, 2002 totals: interest-bearing demand deposits increased $6.8 million (or 4.4%), savings deposits increased $4.2 million (or 8.1%), and time deposits increased $4.2 million (or 1.7%); while demand deposits decreased by $1.3 million (or 2.3%). Borrowings, consisting of customer repurchase agreements, notes payable, treasury, tax, and loan ("TT&L") deposits, federal funds purchased, and Federal Home Loan Bank advances, decreased from $19,491,000 at December 31, 2002 to $15,684,000 at March 31, 2003 (decrease of $3.8 million or 19.5%). Investments totaled $165,265,000 at March 31, 2003, compared to $169,318,000 at December 31, 2002 (a decrease of $4.1 million or 2.4%). Loan balances, net of unearned interest, decreased to $361,712,000 at March 31, 2003, compared to $364,120,000 at December 31, 2002 (a decrease of $2.4 million or 0.7%). This is a reflection of typical lower loan demand during this time of year, as well as seasonal pay-downs in the agricultural sector. Non-performing loans totaled $4,425,000 or 1.23% of net loans at March 31, 2003, as compared to $3,820,000 or 1.07% of net loans at December 31, 2002. 14 For the three months ended March 31, 2003, the subsidiary bank charged off $261,000 of loans and had recoveries of $47,000, compared to charge-offs of $178,000 and recoveries of $87,000 during the three months ended March 31, 2002. The allowance for loan losses is based on factors that include the overall composition of the loan portfolio, types of loans, past loss experience, loan delinquencies, potential substandard and doubtful credits, and such other factors that, in management's reasonable judgment, warrant consideration. The adequacy of the allowance is monitored monthly. At March 31, 2003, the allowance was $2,546,000 which is 57.5% of non-performing loans and 0.70% of total loans, compared with $2,660,000 which was 69.6% of non-performing loans and 0.73% of total loans at December 31, 2002. At March 31, 2003, impaired loans totaled $2,135,000 compared to $2,230,000 at December 31, 2002. Loans 90 days or more past due and still accruing interest at March 31, 2003 were $1,000,000, compared to $23,000 at December 31, 2002. Although the balances of non-performing and impaired loans have increased from the level of prior years, the total continues to be concentrated in a few credits. Additionally, approximately 85% of the balance of loans 90 days or more past due has subsequently paid-off. There is a specific loan loss reserve of $173,000 established for impaired loans as of March 31, 2003 and December 31, 2002. PNBC's management analyzes the allowance for loan losses monthly and believes the current level of allowance is adequate to meet probable losses as of March 31, 2003. CAPITAL RESOURCES ----------------- Federal regulations require all financial institutions to evaluate capital adequacy by the risk-based capital method, which makes capital requirements more sensitive to the differences in the level of risk assets. At March 31, 2003 total risk-based capital of PNBC was 12.22%, compared to 11.74% at December 31, 2002. The Tier 1 capital ratio increased from 7.80% at December 31, 2002, to 7.89% at March 31, 2003. Total stockholders' equity to total assets at March 31, 2003 decreased to 8.59% from 8.70% at December 31, 2002. LIQUIDITY --------- Liquidity is measured by a financial institution's ability to raise funds through deposits, borrowed funds, capital, or the sale of assets. Additional sources of liquidity include cash flow from the repayment of loans. Major uses of cash include the origination of loans and purchase of investment securities. Cash flows provided by financing, operating, and investing activities, resulted in a net increase in cash and cash equivalents of $17,969,000 from December 31, 2002 to March 31, 2003. This increase was due to a net increase in deposits, as well as a net decrease in loans and investments. For more detailed information, see PNBC's Consolidated Statements of Cash Flows. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK ------------------------------------------------- The subsidiary bank is party to financial instruments with off balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the subsidiary bank has in particular classes of financial instruments. 15 The subsidiary bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The subsidiary bank uses the same credit policies in making commitments and conditional obligations as they do for on-balance-sheet instruments. At March 31, 2003 and commitments to extend credit and standby letters of credit were approximately $89,040 and $1,792, respectively. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The subsidiary bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, by the subsidiary bank upon extension of credit is based on management's credit evaluation of the counterparty. Collateral held varies, but may include real estate, accounts receivable, inventory, property, plant and equipment, and income-producing properties. Standby letters of credit are conditional commitments issued by the subsidiary bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The subsidiary bank secures the standby letters of credit with the same collateral used to secure the loan. LEGAL PROCEEDINGS ----------------- There are various claims pending against PNBC's subsidiary bank, arising in the normal course of business. Management believes, based upon consultation with legal counsel, that liabilities arising from these proceedings, if any, will not be material to PNBC's financial condition. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ---------------------------------------------------------- There has been no material change in market risk since December 31, 2002, as reported in PNBC's 2002 Annual Report on Form 10-K. EFFECTS OF INFLATION -------------------- The consolidated financial statements and related consolidated financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America and practices within the banking industry which require the measurement of financial condition and operating results in terms of historical dollars, without considering the changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. 16 PRINCETON NATIONAL BANCORP, INC. AND SUBSIDIARY The following table sets forth (in thousands) details of average balances, interest income and expense, and resulting annualized rates for the Corporation for the periods indicated, reported on a fully taxable equivalent basis, using a tax rate of 34%. -------------------------------------------------------------------------- THREE MONTHS ENDED, MARCH 31, 2003 Three Months Ended, March 31, 2002 -------------------------------------------------------------------------- AVERAGE YIELD/ Average Yield/ BALANCE INTEREST COST Balance Interest Cost -------- -------- -------- -------- -------- ------- AVERAGE INTEREST-EARNING ASSETS Interest-bearing deposits $ 5,797 $ 16 1.12% $ 6,585 $ 25 1.54% Taxable investment securities 115,299 1,177 4.14% 97,050 1,307 5.46% Tax-exempt investment securities 51,753 950 7.44% 48,524 915 7.64% Federal funds sold 7,219 20 1.12% 8,759 35 1.62% Net loans 358,500 5,988 6.77% 336,113 6,287 7.59% -------- -------- -------- -------- Total interest-earning assets 538,567 8,151 6.14% 497,030 8,569 6.99% -------- -------- -------- -------- Average non-interest earning assets 50,262 51,551 -------- -------- Total average assets $588,829 $548,581 ======== ======== AVERAGE INTEREST-BEARING LIABILITIES Interest-bearing demand deposits $158,474 560 1.43% $118,822 539 1.84% Savings deposits 53,437 103 0.78% 56,452 200 1.44% Time deposits 247,206 2,106 3.46% 246,246 2,710 4.46% Interest-bearing demand notes issued to the U.S. Treasury 747 2 1.16% 1,370 7 1.98% Federal funds purchased and securities repurchase agreements 9,047 17 0.78% 11,913 33 1.14% Advances from Federal Home Loan Bank 5,757 78 5.53% 6,425 88 5.58% Borrowings 1,300 10 3.25% 1,550 15 3.81% -------- -------- -------- -------- Total interest-bearing liabilities 475,968 2,878 2.45% 442,780 3,591 3.29% -------- -------- -------- -------- Net yield on average interest-earning assets $ 5,273 3.97% $ 4,978 4.06% ======== ======== Average non-interest-bearing liabilities 62,027 57,973 Average stockholders' equity 50,834 47,829 -------- -------- Total average liabilities and stockholders' equity $588,829 $548,581 ======== ======== 17 SCHEDULE 7. CONTROLS AND PROCEDURES (a) Disclosure controls and procedures. Within 90 days before filing this report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Our disclosure controls and procedures are the controls and other procedures that we designed to ensure that we record, process, summarize and report in a timely manner the information we must disclose in reports that we file with or submit to the SEC. Tony J. Sorcic, President and Chief Executive Officer, and Todd D. Fanning, Vice-President and Chief Financial Officer, reviewed and participated in this evaluation. Based on this evaluation, Messrs. Sorcic and Fanning concluded that, as of the date of their evaluation, our disclosure controls were effective. (b) Internal controls. Since the date of the evaluation described above, there have not been any significant changes in our internal accounting controls or in other factors that could significantly affect those controls. 18