Cardinal Bankshares (CDBK) 10-K 2009 FY Annual report

U.S. Securities and Exchange Commission

Washington, D.C. 20549

Form 10-K

(Mark One)

x Annual Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2009

or

¨ Transition Report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from            to            

Commission file no. 0-28780

Cardinal Bankshares Corporation

Virginia	54-1804471
(State of Incorporation)	(IRS Employer Identification No.)

101 Jacksonville Circle

Floyd, Virginia 24091

(Address of Principal executive offices)

(540) 745-4191

(Registrant’s telephone number)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $10.00 per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    ¨  Yes    x  No

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 past 90 days.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨.    No  ¨.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.        .

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. (Check one):

Large Accelerated Filer	¨	Accelerated Filer	¨
Non-accelerated Filer	¨	Smaller Reporting Company	x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    ¨  Yes    x  No

The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $10,548,360 as of March 10, 2010.

1,535,733 shares of the Issuer’s common stock were issued and outstanding as of March 10, 2010.

DOCUMENTS INCORPORATED BY REFERENCE

The annual report to security holders for fiscal year ended December 31, 2009 is incorporated by reference into Form 10-K Part II, Items 6, 7 and 8, and Part IV, Item 15. The issuer’s Proxy Statement dated March 26, 2010 is incorporated by reference into Form 10-K Part III, Items 10, 11, 12, 13 and 14.

PART I

ITEM 1. BUSINESS

(A) BUSINESS DEVELOPMENT

Cardinal Bankshares Corporation (“Cardinal” or the “Company”) was incorporated as a Virginia corporation on March 12, 1996 to acquire the stock of Bank of Floyd (the “Bank”). The Bank was acquired by the Company on June 30, 1996.

The Bank was organized as a state chartered bank on February 24, 1951 through the consummation of a plan of consolidation between two state chartered community banks then operating in Floyd County, Virginia.

The Bank and its wholly owned subsidiary, FBC, Inc., are incorporated and operate under the laws of the Commonwealth of Virginia. As a state chartered Federal Reserve member, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions and the Federal Reserve. FBC, Inc.’s assets and operations consist primarily of minority interests in title insurance companies.

(B) DESCRIPTION OF THE BUSINESS

The principal business of the Company and Bank is to provide comprehensive individual and corporate banking services through the Bank’s main office in Floyd, Virginia, and branch offices in Hillsville, Christiansburg, Roanoke, Salem, Willis and Fairlawn, Virginia. The Bank’s wholly owned subsidiary, FBC, Inc., has interests in Virginia Title Center, LLC as well as Virginia Bankers Insurance Center, LLC, both of which act as title insurance companies. FBC, Inc. also has an interest in VBA Investment Services, LLC.

(1) SERVICES

The Bank is a full service retail commercial bank offering a wide range of services, including demand and time deposits as well as installment, mortgage and other consumer lending services. The Bank makes seasonal and term commercial loans, both alone and in conjunction with other banks or governmental agencies.

(2) COMPETITIVE CONDITIONS

The bank business is highly competitive. The Company competes as a financial intermediary with other commercial banks, savings and loan associations, credit unions and money market mutual funds operating in its trade area and elsewhere. As of December 31, 2009, there were three commercial banks (one of which is the Bank) operating a total of three offices in Floyd County, Virginia. The two competing institutions are not locally owned.

Floyd County generates approximately 55% of the Bank’s total deposits. In the other parts of the Bank’s trade area (the Virginia counties of Roanoke, Montgomery, Carroll and Pulaski and the Cities of Roanoke and Salem, Virginia), there are a number of locally owned community banks, statewide banking organizations, and affiliate banks of southeast regional bank holding companies in operation.

2

(3) CUSTOMERS

Deposits are derived from a broad base of customers in its trade area. No material portion of deposits have been obtained from a single person or a few persons (including Federal, State, and local governments and agencies thereunder), the loss of which would have a materially adverse effect on the business of the Bank.

The majority of loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Company’s market area. The majority of such customers are also depositors. The Company generally does not extend credit to any single borrower or group of related borrowers in excess of approximately $2.7 million. Although the Company has a reasonably diversified loan portfolio, it has a loan concentration relating to nonresidential buildings and real estate land developers. Total loans to this group amounted to approximately $32.5 million at December 31, 2009 and approximately $31.4 million at December 31, 2008. In addition, the Company has loan concentrations relating to hotels and motels. Total loans to this group amounted to approximately $15.0 million at December 31, 2009 and approximately $15.5 million at December 31, 2008.

(4) RIGHTS

No patents, trademarks, licenses, franchises or concessions held are of material significance to the Company.

(5) NEW SERVICES

The Company has expended no material dollars on research activities relating to new lines of business in the last three years.

(6) ENVIRONMENTAL LAWS

Compliance with Federal, State, or Local provisions regulating the discharge of materials into the environment has not had, nor is it expected to have in the future, a material effect upon the Company’s capital expenditures, earnings or competitive position.

(7) EMPLOYEES

The Bank had 28 officers, 41 full-time employees and 6 part-time employees as of December 31, 2009.

ITEM 1A. RISK FACTORS

Under the filer category of “smaller reporting company”, as defined in Rule 12b-2 of the Exchange Act, the Company is not required to provide information requested by Part I, Item 1A of its Form 10-K.

ITEM 1B. UNRESOLVED STAFF COMMENTS

NONE

ITEM 2. PROPERTIES

The present headquarters of the Company consists of a three-story brick building, with approximately 21,200 square feet of floor space located at 101 Jacksonville Circle, Floyd, Virginia. The Bank also owns its branch offices in Hillsville, Christiansburg, Roanoke, and Fairlawn Virginia, which have drive-up facilities. The Bank’s Willis, Virginia and Salem, Virginia offices operate from a leased facility.

The Bank also owns a three-story brick building adjacent to its main office which serves as the Bank’s conference room, training room and which provides space for expansion of the financial services now offered.

3

ITEM 3. LEGAL PROCEEDINGS

NONE

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

(A) The Company’s stock is traded on the OTC Bulletin Board under the symbol CDBK. The following table shows the trading ranges of the Common Stock for the previous five years.

Year	High		Low
2009	$	12.00	$	7.17
2008	$	19.00	$	10.80
2007	$	20.15	$	18.00
2006	$	21.50	$	19.10
2005	$	23.50	$	20.00

The approximate number of holders of the Bank’s 1,535,733 Common Stock Securities as of December 31, 2009, is 641.

(C) Dividends paid for 2009 were $0.16 and 2008 were $0.61 per share owned. The Company’s ability to declare and pay dividends in the future is dependent upon its consolidated net income, fiscal and general business condition. Subject to these considerations, as well as, laws and regulations governing the payment of dividends, the Company may declare dividends at the discretion of the Board of Directors only. The Company currently expects that dividends will continue to be paid in the foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA

The information required by Item 6 of Form 10-K appears in the Company’s 2009 Annual Report to Stockholders and is incorporated herein by reference.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The information required by Item 7 of Form 10-K appears in the Company’s 2009 Annual Report to Stockholders and is incorporated herein by reference.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Under the filer category of “smaller reporting company”, as defined in Rule 12b-2 of the Exchange Act, the Company is not required to provide information requested by Part II., Item 7A. of its Form 10-K.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by Item 8 of Form 10-K appears in the Company’s 2009 Annual Report to Stockholders and is incorporated herein by reference.

4

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

NONE

ITEM 9A(T). CONTROLS AND PROCEDURES

Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and procedures in accordance with Rule 13a-14 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based on the evaluation, the Chief Executive Officer and Principal Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in enabling us to record, process, summarize and report in a timely manner the information required to be disclosed in reports we file under the Exchange Act.

No change in our internal control over financial reporting occurred during our fourth quarter of 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Management’s Annual Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in theExchange Act Rules 13a-15(f).A system of internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

Under the supervision and with the participation of management, including the principal executive officer and the principal financial officer, the Company’s management has evaluated the effectiveness of its internal control over financial reporting as of December 31, 2009 based on the criteria established in a report entitled“Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission”and the interpretive guidance issued by the Commission in Release No. 34-55929. Based on this evaluation, the Company’s management has evaluated and concluded that the Company’s internal control over financial reporting was effective as of December 31, 2009.

The Company is continuously seeking to improve the efficiency and effectiveness of its operations and of its internal controls. This results in modifications to its processes throughout the Company. However, there has been no change in its internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. The Company’s registered public accounting firm was not required to issue an attestation on its internal controls over financial reporting pursuant to temporary rules of the Securities and Exchange Commission.

ITEM 9B. OTHER INFORMATION

NONE

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information required by Item 10 of Form 10-K appears in the Company’s Proxy Statement for the 2010 Annual Meeting and is incorporated herein by reference.

5

ITEM 11. EXECUTIVE COMPENSATION

The information required by Item 11 of Form 10-K appears in the Company’s Proxy Statement for the 2010 Annual Meeting and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by Item 12 of Form 10-K appears in the Company’s Proxy Statement for the 2010 Annual Meeting and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by Item 13 of Form 10-K appears in the Company’s Proxy Statement for the 2010 Annual Meeting and is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by Item��14 of Form 10-K appears in the Company’s Proxy Statement for the 2010 Annual Meeting and is incorporated herein by reference.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a) The following documents are filed as part of the report:

	Page Number
1.      Financial Statements:
Report of Independent Registered Public Accounting Firm	12
Consolidated Balance Sheets - December 31, 2009 and 2008	13
Consolidated Statements of Income - Years ended December 31, 2009 and 2008	14
Consolidated Statements of Stockholders’ Equity - Years ended December 31, 2009 and 2008	15
Consolidated Statements of Cash Flows - Years ended December 31, 2009 and 2008	16
Notes to Consolidated Financial Statements	17
2.      Financial Statement Schedules:
All schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements or related notes.

6

3.      Exhibits:

13.1       2009 Annual Report to Stockholders (Such Report, except to the extent incorporated herein by reference, is being furnished for the information of the Commission only and is not deemed to be filed as part of this Report on Form 10-K)

14          Code of Ethics for Senior Officers to Rule 13a-14(a)

31.1       Certification of Chief Executive Officer pursuant to Rule 13a-14(a)

31.2       Certification of Principal Financial Officer pursuant to Rule 13a-14(a)

32          Certification of Chief Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350

FINANCIAL STATEMENT SCHEDULES

See Item 15(a) 2 above.

7

SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

CARDINAL BANKSHARES CORPORATION

/S/    RONALD LEON MOORE	/S/    J. ALAN DICKERSON
Ronald Leon Moore	J. Alan Dickerson
Chairman, President & Chief Executive Officer	Vice President, Controller & Chief Financial Officer
Date:    March 10, 2010	Date:    March 10, 2010

In accordance with the Exchange Act, this report has to be signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature	Title	Date
/S/    RONALD LEON MOORE	Director, Chairman, President & Chief Executive Officer	March 10, 2010
Ronald Leon Moore
/S/    JOSEPH HOWARD CONDUFF, JR.	Director & Chairman of Audit Committee	March 10, 2010
Joseph Howard Conduff, Jr.
/S/    W. R. GARDNER, JR.	Vice-Chairman & Director	March 10, 2010
W. R. Gardner, Jr.
/S/    KEVIN D. MITCHELL	Director	March 10, 2010
Kevin D. Mitchell
/S/    A. CAROLE PRATT	Director	March 10, 2010
A. Carole Pratt
/S/    G. HARRIS WARNER, JR.	Director	March 10, 2010
G. Harris Warner, Jr.

8

INDEX TO EXHIBITS

Exhibit No.	Description
13.1	2009 Annual Report to Stockholders (Such Report, except to the extent incorporated herein by reference, is being furnished for the information of the Commission only and is not deemed to be filed as part of this Report on Form 10-K)
14	Code of Ethics for Senior Officers to Rule 13a-14(a)
31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a)
31.2	Certification of Principal Financial Officer pursuant to Rule 13a-14(a)
32	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350

9

Cardinal Bankshares Corporation and Subsidiaries

2009 Annual Report

Market for the Company’s Common Stock, Related Stockholder Matters, Stock Prices and Dividends

The Company’s common stock is traded on the OTC Bulletin Board under the symbol CDBK. Some Internet sites providing stock quotations may require the use of CDBK.OB to access information about Cardinal’s stock. As of December 31, 2009, the Company had issued and outstanding 1,535,733 shares of common stock which were held by approximately 641 stockholders of record.

Set forth below are the high and low (bid quotations/sales prices), known to the management of the Company, for each quarter in the last three fiscal years.

	2009				2008				2007
	High		Low		High		Low		High		Low
First Quarter	$	12.00	$	8.30	$	19.00	$	18.00	$	20.00	$	19.35
Second Quarter		10.01		8.10		18.00		12.95		20.15		19.35
Third Quarter		8.25		7.92		14.25		11.25		20.00		18.65
Fourth Quarter		9.50		7.17		12.55		10.80		19.00		18.00

Cash dividends paid in 2009, 2008 and 2007 were $246 thousand, $937 thousand, and $921 thousand, respectively.

10

Cardinal Bankshares Corporation and Subsidiaries

Selected Historical Financial Information

In thousands, except share, per share and shares outstanding data

	2009			2008			2007			2006			2005
Summary of Operations
Interest income	$	10,984		$	12,169		$	12,958		$	11,913		$	10,684
Interest expense		5,037			5,687			5,892			4,317			3,526
Net interest income		5,947			6,482			7,066			7,596			7,158
Provision for loan losses		1,226			94			(19	)		208			48
Noninterest income		654			765			975			924			759
Noninterest expense		5,089			5,344			5,286			5,038			5,070
Income taxes		(265	)		250			517			763			596
Net income	$	551		$	1,559		$	2,257		$	2,511		$	2,203
Per Share Data
Basic earnings per share	$	.36		$	1.01		$	1.47		$	1.63		$	1.44
Diluted earnings per share		.36			1.01			1.47			1.63			1.44
Cash dividends declared		0.16			0.61			0.60			0.58			0.53
Book value		20.00			19.17			19.48			18.49			17.62
Year-end Balance Sheet Summary
Assets	$	239,410		$	221,040		$	209,261		$	207,849		$	196,235
Loans, net		147,411			146,262			122,783			121,334			128,554
Securities		53,123			45,908			45,838			41,456			37,324
Earning assets		224,988			206,397			194,065			193,811			180,926
Deposits		208,201			189,013			177,649			177,272			167,848
Stockholders’ equity		30,708			29,446			29,913			28,390			27,058
Shares outstanding		1,535,733			1,535,733			1,535,733			1,535,733			1,535,733
Average Daily Balance
Assets	$	230,715		$	215,882		$	211,809		$	193,688		$	191,346
Loans, net		145,253			134,077			118,755			123,775			128,096
Securities		44,348			46,115			43,681			37,672			38,299
Earning assets		217,357			202,148			197,933			179,695			177,439
Deposits		199,375			183,980			179,973			164,051			162,126
Stockholders’ equity		29,723			30,137			29,314			28,139			26,662
Weighted average shares outstanding		1,535,733			1,535,733			1,535,733			1,535,733			1,535,733
Selected Ratios
Return on average assets		.24	%		.72	%		1.07	%		1.30	%		1.15	%
Return on average equity		1.85	%		5.17	%		7.70	%		8.92	%		8.26	%
Dividends declared as percent of net income		44.4	%		60.1	%		40.82	%		35.58	%		36.81	%
Net interest margin (tax-equivalent basis)		2.99	%		3.47	%		3.74	%		4.41	%		4.22	%
Allowance for loan losses as a percentage of total loans		1.78	%		1.12	%		1.34	%		1.33	%		1.10	%
Average equity to average assets		12.88	%		13.96	%		13.84	%		14.53	%		13.93	%
Risk-based capital		19.94	%		19.90	%		22.26	%		21.71	%		20.42	%

11

Report of Independent Registered Public Accounting Firm

Board of Directors and Stockholders

Cardinal Bankshares Corporation

Floyd, Virginia

We have audited the consolidated balance sheets of Cardinal Bankshares Corporation and subsidiaries as of December 31, 2009 and 2008 and the related consolidated financial statements of income, changes in stockholders’ equity, and cash flows for each of the two years ended December 31, 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cardinal Bankshares Corporation and subsidiaries at December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the two years ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.

We were not engaged to examine management’s assertion about the effectiveness of Cardinal Bankshares Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2009 included in the Form 10-K and, accordingly, we do not express an opinion thereon.

Galax, Virginia

March 10, 2010

Cardinal Bankshares Corporation and Subsidiaries

Consolidated Balance Sheets

December 31, (In thousands, except share data)	2009			2008
Assets
Cash and due from banks	$	3,498		$	3,299
Interest-bearing deposits in banks		184			227
Federal funds sold		22,175			12,875
Investment securities available for sale, at fair value		36,684			28,868
Investment securities held to maturity (fair value approximates $16,069 and $16,642 at December 31, 2009 and 2008, respectively)		15,864			16,506
Restricted equity securities		575			534
Total loans		150,081			147,921
Allowance for loan losses		(2,670	)		(1,659	)
Net loans		147,411			146,262
Bank premises and equipment, net		3,792			4,000
Accrued interest receivable		1,031			1,134
Foreclosed assets		261			289
Bank owned life insurance		5,115			4,951
Other assets		2,820			2,095
Total assets	$	239,410		$	221,040
Liabilities and Stockholders’ Equity
Liabilities
Noninterest-bearing deposits	$	27,294		$	26,975
Interest-bearing deposits		180,907			162,038
Total deposits		208,201			189,013
Accrued interest payable		143			222
Other liabilities		358			2,359
Total liabilities		208,702			191,594
Commitments and contingencies		—			—
Stockholders’ equity
Common stock, $10 par value; 5,000,000 shares authorized; 1,535,733 shares issued and outstanding at December 31, 2009 and 2008		15,357			15,357
Additional paid-in capital		2,925			2,925
Retained earnings		12,716			12,411
Accumulated other comprehensive loss		(290	)		(1,247	)
Total stockholders’ equity		30,708			29,446
Total liabilities and stockholders’ equity	$	239,410		$	221,040

See Notes to Consolidated Financial Statements

13

Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Income

Years ended December 31, (In thousands, except share and per share data)	2009			2008
Interest and dividend income
Loans and fees on loans	$	8,995		$	9,456
Federal funds sold		49			171
Investment securities:
Taxable		1,162			1,369
Exempt from federal income tax		772			876
Dividend income		4			26
Deposits with banks		2			271
Total interest income		10,984			12,169
Interest expense
Deposits		5,037			5,687
Total interest expense		5,037			5,687
Net interest income		5,947			6,482
Provision for loan losses		1,226			94
Net interest income after provision for loan losses		4,721			6,388
Noninterest income
Service charges on deposit accounts		186			208
Other service charges and fees		113			106
Net realized gains on sales of securities		50			39
Income on bank owned life insurance		164			194
Other income		141			218
Total noninterest income		654			765
Noninterest expense
Salaries and employee benefits		2,777			3,271
Occupancy and equipment		640			724
Legal and professional		256			396
Bank franchise tax		141			67
Data processing services		186			231
FDIC insurance premiums		466			26
Foreclosed assets, net		1			—
Other operating expense		622			629
Total noninterest expense		5,089			5,344
Income before income taxes		286			1,809
Income tax expense (benefit)		(265	)		250
Net income	$	551		$	1,559
Basic earnings per share	$	.36		$	1.01
Diluted earnings per share	$	.36		$	1.01
Weighted average basic shares outstanding		1,535,733			1,535,733
Weighted average diluted shares outstanding		1,535,733			1,535,733

See Notes to Consolidated Financial Statements

14

Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity and

Comprehensive Income

(In thousands)	Common Stock		Additional Paid-in Capital		Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total
Balance, December 31, 2007	$	15,357	$	2,925	$	11,789		$	(158	)	$	29,913
Comprehensive income
Net income		—		—		1,559			—			1,559
Net unrealized securities losses arising during the period, net of taxes of $(199)		—		—		—			(387	)		(387	)
Realized securities gains, net of taxes of $(13)		—		—		—			(26	)		(26	)
Adjustment for pension, net of taxes of $(348)		—		—		—			(676	)		(676	)
Total comprehensive income												470
Cash dividends declared ($0.61 per share)		—		—		(937	)		—			(937	)
Balance, December 31, 2008		15,357		2,925		12,411			(1,247	)		29,446
Comprehensive income
Net income		—		—		551			—			551
Net unrealized securities gains arising during the period, net of taxes of $131		—		—		—			254			254
Realized securities gains, net of taxes of $(17)		—		—		—			(34	)		(34	)
Adjustment for change in pension plans, net of taxes of $379		—		—		—			737			737
Total comprehensive income												1,508
Cash dividends declared ($0.16 per share)		—		—		(246	)		—			(246	)
Balance, December 31, 2009	$	15,357	$	2,925	$	12,716		$	(290	)	$	30,708

See Notes to Consolidated Financial Statements

15

Cardinal Bankshares Corporation and Subsidiaries

Consolidated Statements of Cash Flows

Years ended December 31, (In thousands)	2009			2008
Cash flows from operating activities
Net income	$	551		$	1,559
Adjustments to reconcile net income to net cash (used) provided by operations:
Depreciation and amortization		277			313
Accretion of discount on securities, net of amortization of premiums		89			22
Provision for (recovery of) loan losses		1,226			94
Deferred income taxes benefit (expense)		(402	)		(25	)
Net realized gains on securities		(50	)		(39	)
Net realized (gain) loss on sale of foreclosed assets		(9	)		20
Deferred compensation and pension expense (benefit)		(635	)		110
Changes in assets and liabilities:
Accrued income		103			(89	)
Other assets		(979	)		(176	)
Accrued interest payable		(79	)		11
Other liabilities		(250	)		(263	)
Net cash (used) provided by operating activities		(158	)		1,537
Cash flows from investing activities
Net (increase) decrease in interest-bearing deposits in banks		43			15,284
Net (increase) decrease in federal funds sold		(9,300	)		(4,075	)
Purchases of available for sale securities		(24,204	)		(14,667	)
Sales of available for sale securities		1,988			1,234
Maturities, calls and paydowns of available for sale securities		14,700			10,258
Purchases of held to maturity securities		(2,258	)		(409	)
Maturities, calls and paydowns of held to maturity securities		2,894			2,903
Call (purchase) of restricted equity securities		(41	)		2
Net (increase) decrease in loans		(2,511	)		(23,862	)
Net purchases of property and equipment		(69	)		(51	)
Proceeds from sale of foreclosed assets		173			192
Net cash used by investing activities		(18,585	)		(13,191	)
Cash flows from financing activities
Net increase (decrease) in noninterest-bearing deposits		319			(2,587	)
Net increase (decrease) in interest-bearing deposits		18,869			13,951
Dividends paid		(246	)		(937	)
Net cash provided by financing activities		18,942			10,427
Net increase (decrease) in cash and cash equivalents		199			(1,227	)
Cash and cash equivalents, beginning		3,299			4,526
Cash and cash equivalents, ending	$	3,498		$	3,299
Supplemental disclosures of cash flow information
Interest paid	$	5,116		$	5,676
Income taxes paid	$	14		$	502
Supplemental disclosures of noncash activities
Other real estate acquired in settlement of loans	$	136		$	237

See Notes to Consolidated Financial Statements

16

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies

Organization

Cardinal Bankshares Corporation (the “Company”) was incorporated as a Virginia corporation on March 12, 1996 to acquire the stock of Bank of Floyd (the “Bank”). The Bank was acquired by the Company on June 30, 1996.

Bank of Floyd and its wholly-owned subsidiary, FBC, Inc., are incorporated and operate under the laws of the Commonwealth of Virginia. As a state chartered Federal Reserve member, the Bank is subject to regulation by the Virginia Bureau of Financial Institutions and the Federal Reserve. The Bank serves the counties of Floyd, Carroll, Montgomery, Roanoke and Pulaski, Virginia and the Cities of Roanoke, Christiansburg, Salem and Fairlawn, Virginia, through seven banking offices. FBC Inc.’s assets and operations consist primarily of annuity sales and minority interests in an insurance company and a title insurance company.

The accounting and financial reporting policies of the Company conform to generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.

Principles of Consolidation

The consolidated financial statements of the Company include the accounts of the Company, the Bank and FBC, Inc. All material intercompany transactions and balances have been eliminated.

Critical Accounting Policy

Management believes the policy with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity. Management must make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could cause reported results to differ materially. This critical policy and its application are periodically reviewed with the Audit Committee and Board of Directors.

Business Segments

The Company reports its activities as a single business segment. In determining proper segment definition, the Company considers the materiality of the potential segment and components of the business about which financial information is available and regularly evaluated, relative to resource allocation and performance assessment.

Advertising Expense

The Company expenses advertising costs as they are incurred. Advertising expense for the years presented is not material to the financial statements.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions in the application of certain of its accounting policies that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. As a result of unanticipated events or circumstances, actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan and foreclosed real estate losses, management obtains independent appraisals for significant properties.

17

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies, continued

Use of Estimates, continued

The majority of the Company’s loan portfolio consists of loans in Southwest Virginia. Accordingly, the ultimate collectibility of a substantial portion of the Company’s loan portfolio and the recovery of a substantial portion of the carrying amount of foreclosed real estate are susceptible to changes in local market conditions. The regional economy is diverse, but is influenced by the agricultural, textile and governmental segments.

While management uses available information to recognize loan and foreclosed real estate losses, future additions to the allowances may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as a part of their routine examination process, periodically review the Company’s allowances for loan and foreclosed real estate losses. Such agencies may require additions to the allowances based on their judgments about information available to them at the time of their examinations. Because of these factors, it is reasonably possible that the allowances for loan and foreclosed real estate losses may change materially in the near term.

Cash and Cash Equivalents

For purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents are defined as those amounts included in the balance sheet caption ���cash and due from banks.”

Interest-Bearing Deposits in Banks

Interest-bearing deposits in banks mature in one year and are carried at cost.

Trading Securities

The Company does not hold securities for short-term resale and therefore does not maintain a trading securities portfolio.

Securities Held to Maturity

Bonds, notes, and debentures for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity or to call dates.

Securities Available for Sale

Available for sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as held to maturity securities.

Unrealized holding gains and losses, net of tax, on available for sale securities are reported as a net amount in a separate component of stockholders’ equity. Realized gains and losses on the sale of available for sale securities are recorded on the trade date and are determined using the specific identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity or to call dates.

Declines in the fair value of individual held to maturity and available for sale securities below cost, that are other than temporary, are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses.

Loans Receivable

Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off, are reported at their outstanding principal amount adjusted for charge-offs, the allowance for loan losses, deferred fees or costs on originated loans, and unamortized premiums or discounts on purchased loans.

18

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies, continued

Loans Receivable, continued

Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment of the yield of the related loan. Discounts and premiums on any purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Discounts and premiums on any purchased consumer loans are recognized over the expected lives of the loans using methods that approximate the interest method.

Interest is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received. When facts and circumstances indicate the borrower has regained the ability to meet required payments, the loan is returned to accrual status. Past due status of the loan is determined based on contractual terms.

Allowance for Loan Losses

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as impaired, for which an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.

19

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies, continued

Premises and Equipment

Land is carried at cost. Bank premises, furniture and equipment are carried at cost, less accumulated depreciation and amortization computed principally by the straight-line method over the following estimated useful lives:

	Years
Buildings and improvements	20-40
Furniture and equipment	5-20

Foreclosed Properties

Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value less cost to sell at the date of foreclosure. After foreclosure, valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in operations on foreclosed real estate. The historical average holding period for such properties is in excess of 23 months.

Pension Plan

A noncontributory defined benefit pension plan is provided for all employees who meet eligibility requirements. To be eligible, an employee must have been hired prior to October 1, 2008, be 21 years of age and have completed one year of service. Plan benefits are based on final average compensation and years of service. The plan is funded in compliance with the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code of 1986, as amended.

Transfers of Financial Assets

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Income Taxes

Provision for income taxes is based on amounts reported in the statements of income (after exclusion of non-taxable income such as interest on state and municipal securities) and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Deferred income tax liability relating to unrealized appreciation (or the deferred tax asset in the case of unrealized depreciation) on investment securities available for sale is recorded in other liabilities (assets). Such unrealized appreciation or depreciation is recorded as an adjustment to equity in the financial statements and not included in income determination until realized. Accordingly, the resulting deferred income tax liability or asset is also recorded as an adjustment to equity.

20

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 1. Organization and Summary of Significant Accounting Policies, continued

Income Taxes, continued

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50% likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Management is not aware of any material uncertain tax positions and no liability has been recognized at December 31, 2009. Interest and penalties associated with unrecognized tax benefits are classified as additional income taxes in the statement of income.

Basic Earnings per Share

Basic earnings per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period, after giving retroactive effect to stock splits and stock dividends.

Diluted Earning per Share

The computation of diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of those potential common shares. For the years presented, the Company has no potentially dilutive securities outstanding.

Comprehensive Income

Annual comprehensive income reflects the change in the Company’s equity during the year arising from transactions and events other than investments by, and distributions to, stockholders. It consists of net income plus certain other changes in assets and liabilities that are reported as separate components of stockholders’ equity rather than as income or expense.

Financial Instruments

Derivatives that are used as part of the asset/liability management process are linked to specific assets or liabilities and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. In addition, forwards and option contracts must reduce an exposure’s risk, and for hedges of anticipatory transactions, the significant terms and characteristics of the transaction must be identified and the transactions must be probable of occurring. All derivative financial instruments held or issued by the Bank are held or issued for purposes other than trading.

In the ordinary course of business the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit and commercial and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.

The Company does not utilize interest-rate exchange agreements or interest-rate futures contracts.

21

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Fair Value of Financial Instruments

Generally accepted accounting principles (“GAAP”) define fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company determines the fair values of its financial instruments based on the fair value hierarchy established per GAAP which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Investment securities available-for-sale, loans held for sale and servicing assets are recorded at fair value on a recurring basis. Certain impaired loans are carried at fair value on a non-recurring basis.

Recently Issued Accounting Pronouncements

The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting and or disclosure of financial information by the Company.

In June 2009, the Financial Accounting Standards Board (“FASB”) issued guidance which restructured generally accepted accounting principles (“GAAP”) and simplified access to all authoritative literature by providing a single source of authoritave nongovernmental GAAP. The guidance is presented in a topically organized structure referred to as the FASB Accounting Standards Codification (“ASC”). The new structure is effective for interim or annual periods ending after September 15, 2009. All existing accounting standards have been superseded and all other accounting literature not included is considered nonauthoritative.

The FASB issued new accounting guidance on accounting for transfers of financial assets in June 2009. The guidance limits the circumstances in which a financial asset should be derecognized when the transferor has not transferred the entire financial asset by taking into consideration the transferor’s continuing involvement. The standard requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of a transfer of financial assets accounted for as a sale. The concept of a qualifying special-purpose entity is no longer applicable. The standard is effective for the first annual reporting period that begins after November 15, 2009, for interim periods within the first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company does not expect the guidance to have any impact on the Company’s financial statements. The ASC was amended in December 2009, to include this guidance.

Guidance was issued in June 2009 requiring a company to analyze whether its interest in a variable interest entity (“VIE”) gives it a controlling financial interest that should be included in consolidated financial statements. A company must assess whether it has an implicit financial responsibility to ensure that the VIE operates as designed when determining whether it has the power to direct the activities of the VIE that significantly impact its economic performance, making it the primary beneficiary. Ongoing reassessments of whether a company is the primary beneficiary are also required by the standard. This guidance amends the criteria to qualify as a primary beneficiary as well as how to determine the existence of a VIE. The standard also eliminates certain exceptions that were previously available. This guidance is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. Comparative disclosures will be required for periods after the effective date. The Company does not expect the guidance to have any impact on the Company’s financial position. An update was issued in December 2009, to include this guidance in the ASC.

An update was issued in October 2009 to provide guidance requiring companies to allocate revenue in multi-element arrangements. Under this guidance, products or services (deliverables) must be accounted for separately rather than as a combined unit utilizing a selling price hierarchy to determine the selling price of a deliverable. The selling price is based on vendor-specific evidence, third-party evidence or estimated selling price. The amendments in the update are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. The Company does not expect the update to have an impact on its financial statements.

22

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Recently Issued Accounting Pronouncements, continued

In October 2009, updated guidance was issued to provide for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance. At the date of issuance, a share-lending arrangement entered into on an entity’s own shares should be measured at fair value in accordance with prior guidance and recognized as an issuance cost, with an offset to additional paid-in capital. Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs. The amendment also requires several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement. The effective dates of the amendment are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009. The Company has no plans to issue convertible debt and, therefore, does not expect the update to have an impact on its financial statements.

In January 2010, guidance was issued to alleviate diversity in the accounting for distributions to shareholders that allow the shareholder to elect to receive their entire distribution in cash or shares but with a limit on the aggregate amount of cash to be paid. The amendment states that the stock portion of a distribution to shareholders that allows them to elect to receive cash or shares with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance. The amendment is effective for interim and annual periods ending on or after December 15, 2009 and had no impact on the Company’s financial statements.

Also in January 2010, an amendment was issued to clarify the scope of subsidiaries for consolidation purposes. The amendment provides that the decrease in ownership guidance should apply to (1) a subsidiary or group of assets that is a business or nonprofit activity, (2) a subsidiary that is a business or nonprofit activity that is transferred to an equity method investee or joint venture, and (3) an exchange of a group of assets that constitutes a business or nonprofit activity for a noncontrolling interest in an entity. The guidance does not apply to a decrease in ownership in transactions related to sales of in substance real estate or conveyances of oil and gas mineral rights. The update is effective for the interim or annual reporting periods ending on or after December 15, 2009 and had no impact on the Company’s financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Reclassifications

Certain reclassifications have been made to the prior years’ financial statements to place them on a comparable basis with the current year. Net income and stockholders’ equity previously reported were not affected by these reclassifications.

Note 2. Restrictions on Cash and Due from Banks

To comply with banking regulations, the Company is required to maintain certain average cash reserve balances. The daily average cash reserve requirement was approximately $800 thousand for both the two-week periods including December 31, 2009 and 2008.

23

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 3. Securities

Debt and equity securities have been classified in the Consolidated Balance Sheets according to management’s intent. The carrying amount of securities and their approximate fair values at December 31 follow:

2009 (In thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses		Fair Value
Available for sale
Government sponsored enterprises	$	4,908	$	2	$	35	$	4,875
State and municipal securities		2,661		55		19		2,697
Mortgage-backed securities		25,500		281		135		25,646
Other securities		4,056		—		590		3,466
	$	37,125	$	338	$	779	$	36,684
Held to maturity
State and municipal securities	$	15,834	$	364	$	159	$	16,039
Mortgage-backed securities		30		—		—		30
	$	15,864	$	364	$	159	$	16,069
2008 (In thousands)
Available for sale
Government sponsored enterprises	$	5,733	$	30	$	4	$	5,759
State and municipal securities		2,918		30		5		2,943
Mortgage-backed securities		16,942		140		117		16,965
Other securities		4,049		51		899		3,201
	$	29,642	$	251	$	1,025	$	28,868
Held to maturity
State and municipal securities	$	16,468	$	283	$	146	$	16,605
Mortgage-backed securities		38		—		1		37
	$	16,506	$	283	$	147	$	16,642

Restricted equity securities, carried at cost, consist of investments in stock of the Federal Home Loan Bank of Atlanta (“FHLB”) and The Federal Reserve of Richmond (Federal Reserve), which are upstream correspondents of the Bank. The FHLB requires financial institutions to make equity investments in the FHLB in order to borrow from it. The Bank is required to hold that stock so long as it borrows from the FHLB. The Federal Reserve requires banks to purchase stock as a condition of membership in the Federal Reserve system.

Investment securities with amortized cost of approximately $8.4 million and $7.0 million at December 31, 2009 and 2008, respectively, were pledged as collateral on public deposits and for other purposes as required or permitted by law.

Gross realized gains for the years ended December 31 are as follows. There were no realized losses in either period.

(In thousands)	2009		2008
Realized gains, available for sale securities	$	48	$	26
Realized gains, held to maturity securities		2		13
	$	50	$	39

24

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 3. Securities, continued

The scheduled maturities of debt securities available for sale and held to maturity at December 31, 2009 were as follows:

(In thousands)	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	—	$	—	$	864	$	869
Due after one year through five years		1,313		1,216		5,408		5,617
Due after five years through ten years		5,816		5,631		4,739		4,821
Due after ten years		29,996		29,837		4,853		4,762
	$	37,125	$	36,684	$	15,864	$	16,069

For mortgage-backed securities, the Company reports maturities based on anticipated lives. Actual results may differ due to interest rate fluctuations.

The following table shows the unrealized losses and related fair values in the Company’s held to maturity and available for sale investment securities portfolios. This information is aggregated by investment category and by the length of time that individual securities have been in a continuous unrealized loss position at December 31, 2009 and 2008.

	Less Than 12 Months				12 Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
December 31, 2009 (In thousands)
Government sponsored enterprises	$	4,232	$	35	$	—	$	—	$	4,232	$	35
State and municipal securities		3,291		94		726		84		4,017		178
Mortgage- backed securities		5,544		77		1,393		58		6,937		135
Other Securities		295		—		2,670		590		2,965		590
Total temporarily impaired securities	$	13,362	$	206	$	4,789	$	732	$	18,151	$	938
December 31, 2008 (In thousands)
Government sponsored enterprises	$	481	$	4	$	—	$	—	$	481	$	4
State and municipal securities		3,413		96		645		55		4,058		151
Mortgage- backed securities		3,409		94		1,545		24		4,954		118
Other Securities		1,135		385		486		514		1,621		899
Total temporarily impaired securities	$	8,438	$	579	$	2,676	$	593	$	11,114	$	1,172

Management considers the nature of the investment, the underlying causes of the decline in market or fair value, the severity and duration of the decline and other evidence, on a security-by-security basis, in determining if the decline in fair value is other than temporary.

At December 31, 2009, the Company had 5 government-sponsored securities with an aggregate unrealized loss of approximately $35 thousand, 11 state and municipal securities with an aggregate unrealized loss of approximately $178 thousand, 12 mortgaged-backed securities with an aggregate unrealized loss of approximately $135 thousand and 8 other securities with an aggregate unrealized loss of approximated $590 thousand. Management does not believe that gross unrealized losses, which totals 5.2% of the amortized costs of the related investment securities, represent an other-than-temporary impairment. The Company has both the ability and the intent to hold all of these securities for a period of time necessary to recover the amortized cost.

25

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 4. Loans Receivable

The major components of loans in the Consolidated Balance Sheets are summarized below:

December 31, (In thousands)	2009			2008
Commercial	$	7,675		$	7,914
Real estate
Construction and land development		17,441			19,735
Residential, 1-4 families		30,039			28,671
Residential, 5 or more families		3,047			2,978
Farmland		1,264			2,089
Nonfarm, nonresidential		80,708			73,820
Agricultural		148			183
Consumer		3,117			3,937
Other		6,992			8,914
Gross loans		150,431			148,241
Unearned discount and net deferred loan fees and costs		(350	)		(320	)
Total loans		150,081			147,921
Allowance for loan losses		(2,670	)		(1,659	)
Net loans	$	147,411		$	146,262
Note 5. Allowance for Loan Losses
Changes in the allowance for loan losses are as follows:
Years ended December 31, (In thousands)	2009			2008
Balance, at January 1	$	1,659		$	1,669
Provision (recovery) charged to expense		1,226			94
Recoveries of amounts charged off		12			11
Amounts charged off		(227	)		(115	)
Balance, at December 31	$	2,670		$	1,659
The following is a summary of information pertaining to impaired and nonaccrual loans at December 31:
(In thousands)	2009			2008
Impaired loans without a valuation allowance	$	2,962		$	—
Impaired loans with a valuation allowance		5,624			2,749
Total impaired loans	$	8,586		$	2,749
Valuation allowance related to impaired loans	$	1,157		$	470
Total nonaccrual loans	$	5,302		$	2,405
Total loans past-due ninety days or more and still accruing	$	382		$	430
	2009			2008
Average investment in impaired loans	$	8,586		$	2,749
Interest income recognized for the year	$	286		$	191
Interest income recognized on a cash basis for the year	$	300		$	191

The Company is not committed to advance additional funds in connection with impaired loans.

26

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 6. Bank Premises and Equipment

Bank premises and equipment included in the Consolidated Balance Sheets are as follows:

December 31, (In thousands)	2009			2008
Land	$	929		$	929
Bank premises		4,462			4,644
Furniture and equipment		540			3,302
Total		5,931			8,875
Less accumulated depreciation		(2,139	)		(4,875	)
Bank premises and equipment, net	$	3,792		$	4,000

During 2009 the Company removed $3.0 million in furniture and equipment from its books for items that were no longer in service. These items had fully depreciated.

The Bank has entered into long-term leases for two of its branch banking facilities under agreements accounted for as operating leases. These leases were renewed in 2009, with the Salem lease expiring in 2014 and the Willis lease expiring in 2012. The Bank also entered into a long-term lease for land for one of its branches. The lease has an initial term of ten years, with automatic renewal in ten year increments terminating in 2046. Rental expense was $79 thousand and $78 thousand for 2009 and 2008, respectively. Future minimum lease payments are as follows:

	(In thousands)
2010	$	79
2011		79
2012		77
2013		77
2014		57
Years thereafter		23
Total	$	392

Note 7. Deposits

The composition of deposits is as follows:

December 31, (In thousands)	2009		2008
Demand deposits, noninterest bearing	$	27,294	$	26,975
NOW and money market accounts		25,112		21,033
Savings deposits		19,497		17,647
Time certificates $100,000 or more		62,724		46,942
Other time certificates		73,574		76,416
Total deposits	$	208,201	$	189,013

At December 31, 2009, the scheduled maturities of time deposits are as follows:

	(In thousands)
2010	$	88,310
2011		29,060
2012		6,146
2013		5,880
2014		6,883
2015		19
Total	$	136,298

27

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 8. Borrowings

The Company has established various credit facilities to provide additional liquidity if and as needed. These include unsecured lines of credit with correspondent banks totaling $8.0 million and a secured line of credit with the Federal Home Loan Bank of Atlanta of approximately $27.6 million. Additional amounts are available from the Federal Home Loan Bank with additional collateral. At December 31, 2009 and 2008, there were no amounts outstanding under these agreements.

Note 9. Employee Benefit Plan

The Bank has a qualified noncontributory, defined benefit pension plan which covers substantially all of its employees. Effective October 1, 2009 the Bank terminated its single employer plan with the Virginia Bankers Association (VBA). In conjunction with this transaction, the Bank adopted the Pentegra Defined Benefit Plan for Financial Institutions (Pentegra), a multiemployer plan. All plan assets and liabilities were transferred from the VBA plan to the Pentegra Plan. GAAP states the determining factor for recording pension expense or a liability for employers participating in a multiemployer plan is the amount of the contribution required for the period. The result of the plan termination required the Bank to reverse its outstanding accrued liability as previously required under accounting guidance for single employer plans. This entry eliminated other liabilities of $1.1 million, Accumulated Other Comprehensive Income of $737 thousand and deferred tax assets of $379 thousand. In addition, the Bank was required to reverse its Accrued Benefit Costs resulting in a one-time income effect of $667 thousand.

The benefits are primarily based on years of service and earnings. The following is a summary of the plan’s funded status:

December 31, (In thousands)	2009			2008
Change in benefit obligation
Benefit obligation at beginning of year	$	3,580		$	3,297
Service cost		135			194
Interest cost		159			253
Actuarial (gain) loss		36			(26	)
Benefits paid		(127	)		(138	)
Plan Termination		(3,783	)		—
Benefit obligation at end of year	$	—		$	3,580
Change in plan assets
Fair value of plan assets at beginning of year	$	1,797		$	2,660
Actual return on plan assets		378			(776	)
Employer contribution		305			51
Benefits paid		(127	)		(138	)
Plan Termination		(2,353	)		—
Fair value of plan assets at end of year	$	—		$	1,797
Change in prepaid (accrued) benefit cost
Prepaid (accrued) benefit cost, beginning	$	(667	)	$	(545	)
Contributions		305			51
Pension cost		—			(173	)
Plan Termination		362			—
Prepaid (accrued) benefit cost, ending	$	—		$	(667	)
Funded status				$	(1,783	)
Unrecognized transitional net assets					(3	)
Unrecognized prior service cost					16
Unrecognized net actuarial (gain) loss					1,103
Net amount recognized				$	(667	)

28

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 9. Employee Benefit Plan, continued

December 31, (In thousands)	2009		2008
Recognized on balance sheet
Other assets	$	—	$	379
Other liabilities		—		(1,783	)
Accumulated other comprehensive income		—		737
Net amount recognized	$	—	$	(667	)
Recognized in accumulated other comprehensive income	$	—	$	(16	)
Unrecognized transitional net assets		—		(1,103	)
Unrecognized prior service cost		—		3
Unrecognized net actuarial (gain) loss		—		379
Prepaid (accrued) benefit cost	$	—	$	(737	)
			2008
Components of net periodic benefit cost
Service cost			$	155
Interest cost				203
Return on plan assets				(222	)
Originating unrecognized asset gain (loss)				—
Amortization				2
Recognized net actuarial (gain) loss				—
Net periodic benefit cost			$	138
Benefit obligation assumptions as of December 31
Discount rate				6.00	%
Expected return on plan assets				8.50	%
Rate of compensation increase				4.00	%
Net periodic benefit cost assumptions as of December 31
Discount rate				6.25	%
Expected return on plan assets				8.50	%
Rate of compensation increase				4.00	%

The accumulated benefit obligation for the defined benefit pension plan was $2.7 million at December 31, 2008. Employer contributions during the year ended 2009 were $254 thousand. Under the new plan, the Company had accrued $45 thousand for contributions to be paid in 2010. The Company expects contributions for 2010 to be approximately $127 thousand.

29

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 10. Deferred Compensation and Life Insurance

Deferred compensation plans have been adopted for certain members of the Board of Directors for future compensation upon retirement. Under plan provisions aggregate annual payments ranging from $2 thousand to $8 thousand are payable for ten years certain, generally beginning at age 65. The liability accrued for compensation deferred under the plan amounts to $36 thousand and $49 thousand at December 31, 2009 and 2008, respectively.

Charges to income are based on present value of future cash payments, discounted at 8%, and amounted to $3 thousand and $4 thousand for 2009 and 2008, respectively.

The Bank is owner and beneficiary of life insurance policies on these directors. Policy cash values, net of policy loans, totaled $68 thousand and $93 thousand at December 31, 2009 and 2008 respectively.

In 2002, the Bank adopted a supplemental executive retirement plan to provide benefits for a member of management. Under plan provisions, aggregate fixed payments of $45 thousand are payable for 20 years certain, beginning on the executive’s retirement date. The liability is calculated by discounting the anticipated future cash flows at 6.10%. The liability accrued for this obligation was $468 thousand at December 31, 2009 and 2008, respectively. Charges to income are based on changes in the cash value of insurance which funds the liability.

Note 11. Fair Value of Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

Cash and due from banks, interest-bearing deposits in banks, federal funds sold: The carrying amounts reported in the balance sheet for these items approximate their fair values.

Securities: Fair values for securities, excluding restricted equity securities, are based on quoted market prices, where available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. The carrying values of restricted equity securities approximate fair values.

Loans receivable: For variable-rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. The carrying amount of accrued interest receivable approximates its fair value.

Deposit liabilities: The fair values disclosed for demand and savings deposits are, by definition, equal to the amount payable on demand at the reporting date. The fair values for certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits. The carrying amount of accrued interest payable approximates fair value.

30

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 11. Fair Value of Financial Instruments, continued

The estimated fair values of the Company’s financial instruments are as follows:

December 31, (In thousands)	2009				2008
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets
Cash and due from banks	$	3,498	$	3,498	$	3,299	$	3,299
Interest-bearing deposits with banks		184		184		227		227
Federal funds sold		22,175		22,175		12,875		12,875
Securities, available for sale		36,684		36,684		28,868		28,868
Securities, held to maturity		15,864		16,069		16,506		16,642
Restricted equity securities		575		575		534		534
Total loans		150,081		150,647		147,921		150,621
Accrued interest receivable		1,031		1,031		1,134		1,134
Financial liabilities
Deposits		208,201		210,364		189,013		191,267
Accrued interest payable		143		143		222		222
Off-balance sheet assets (liabilities)
Commitments to extend credit and standby letter of credit		—		—		—		—

GAAP provides a framework for measuring and disclosing fair value which requires disclosures about the fair value of assets and liabilities recognized in the balance sheet, whether the measurements are made on a recurring basis (for example, available for sale investment securities) or on a nonrecurring basis (for example, impaired loans).

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. GAAP also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The Company utilizes fair value measurements to record fair value adjustments to certain assets and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair Value Hierarchy

The Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine the fair value. These levels are:

Level 1 -	Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2 -	Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3 -	Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of option pricing models, discounted cash flow models and similar techniques.

31

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 11. Fair Value of Financial Instruments, continued

Following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange such as the New York Stock Exchange, Treasury securities that are traded by dealers or brokers in active over-the counter markets and money market funds. Level 2 securities include mortgage backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

Loans

The Company does not record loans at fair value on a recurring basis, however, from time to time, a loan is considered impaired and an allowance for loan loss is established. Loans for which it is probable that payment of interest and principle will not be made in accordance with the contractual terms of the loan are considered impaired. Once a loan is identified as individually impaired, management measures impairment. The fair value of impaired loans is estimated using one of several methods, including the collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring a specific allowance represents loans for which the fair value of expected repayments or collateral exceed the recorded investment in such loans. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observerable market price or a current appraised value, the Company records the loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the loan as nonrecurring Level 3.

Foreclosed Assets

Foreclosed assets are adjusted to fair value upon transfer of the loans to other real estate owned. Real estate acquired in settlement of loans is recorded initially at estimated fair value of the property less estimated selling costs at the date of foreclosure. The initial recorded value may be subsequently reduced by additional allowances, which are charged to earnings if the estimated fair value of the property less estimated selling costs declines below the initial recorded value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Bank records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Bank records the foreclosed asset as nonrecurring Level 3.

32

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 11. Fair Value of Financial Instruments, continued

Assets and Liabilities Recorded as Fair Value on a Recurring Basis

The tables below present the recorded amount of assets measured at fair value on a recurring basis.

(In Thousands) December 31, 2009	Total		Level 1		Level 2		Level 3
Investment securities available for sale	$	36,684	$	4,040	$	32,644	—
Total assets at fair value	$	36,684	$	4,040	$	32,644	—
(In Thousands) December 31, 2008	Total		Level 1		Level 2		Level 3
Investment securities available for sale	$	28,868	$	1,017	$	27,851	—
Total assets at fair value	$	28,868	$	1,017	$	27,851	—

There were no liabilities measured at fair value on a recurring basis at December 31, 2009 and 2008.

Assets and Liabilities Recorded as Fair Value on a Nonrecurring Basis

The Company may be required from time to time, to measure certain assets at fair value on a non-recurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a nonrecurring basis are included in the tables below.

(In Thousands) December 31, 2009	Total		Level 1	Level 2		Level 3
Impaired loans	$	4,653	—	$	4,653	—
Foreclosed assets		261	—		261	—
Total assets at fair value	$	4,914	—	$	4,914	—
(In Thousands) December 31, 2008	Total		Level 1	Level 2		Level 3
Impaired loans	$	2,279	—	$	2,279	—
Foreclosed assets		289	—		289	—
Total assets at fair value	$	2.568	—	$	2.568	—

There were no liabilities measured at fair value on a nonrecurring basis at December 31, 2009 and 2008.

33

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 12. Income Taxes

The components of income tax expense (benefit) are as follows:

Years ended December 31, (In thousands)	2009			2008
Current taxes – federal	$	137		$	275
Deferred taxes – federal		(402	)		(25	)
Income tax expense (benefit)	$	(265	)	$	250

A reconciliation of the expected income tax expense computed by applying the federal statutory rate of 34% to income included in the consolidated statements of income follows:

Years ended December 31, (In thousands)	2009			2008
Expected tax expense	$	97		$	615
Tax exempt interest		(357	)		(353	)
Income on bank owned life insurance		(56	)		(66	)
Other		51			54
Income tax expense (benefit)	$	(265	)	$	250

The Company has analyzed the tax positions taken or expected to be taken in its tax returns and concluded it has no liability related to uncertain tax positions. The Company’s policy is to classify any interest or penalties recognized as interest expense or noninterest expense, respectively. Years ended December 31, 2006 through December 31, 2008 remain open for audit for all major jurisdictions.

The tax effects of temporary timing differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below:

December 31, (In thousands)	2009			2008
Deferred tax assets
Allowance for loan and other real estate losses	$	863		$	530
Interest on non-accrual loans		89			7
Deferred loan interest, fees		119			109
Employee benefit liabilities		293			496
Pension liability		—			379
Alternative minimum tax carryforward		154			—
Net unrealized depreciation on securities available for sale		150			263
Total deferred tax assets		1,668			1,784
Deferred tax liabilities
Prepaid expenses		(57	)		(64	)
Depreciation		(40	)		(45	)
Accretion of discount on investment securities		(46	)		(60	)
Total deferred tax liabilities		(143	)		(169	)
Net deferred tax asset	$	1,525		$	1,615

34

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 12. Income Taxes, continued

Deferred tax assets or liabilities are initially recognized for differences between the financial statement carrying amount and the tax basis of asset and liabilities which will result in future deductible or taxable amounts and operating loss and tax credit carry-forwards. A valuation allowance is then established, as applicable, to reduce the deferred tax asset to the level at which it is “more likely than not” that the tax benefits will be realized. Realization of tax benefits of deductible temporary differences and operating loss or credit carry-forwards depends on having sufficient taxable income of an appropriate character within the carry-back and carry-forward periods. Sources of taxable income that may allow for the realization of tax benefits include (1) taxable income in the current year of prior years that is available through carry-back, (2) future taxable income that will result from the reversal of existing taxable temporary differences, and (3) taxable income generated by future operations. There is no valuation allowance for deferred tax assets as of December 31, 2009 and 2008. It is management’s belief that realization of the deferred tax asset is more likely than not.

Note 13. Commitments and Contingencies

Litigation

Various legal claims also arise from time to time in the normal course of business, which, in the opinion of management, will have no material effect on the Company’s consolidated financial statements.

Financial Instruments with Off-Balance Sheet Risk

The Company’s exposure to loan loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of commitments at December 31 is as follows:

December 31, (In thousands)	2009		2008
Commitments to extend credit	$	21,875	$	10,854
Standby letters of credit		978		446
	$	22,853	$	11,300

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 Company evaluates each customer’s creditworthiness on a case-by-case basis.

The amount of collateral obtained, if deemed necessary upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, crops, livestock, inventory, property and equipment, residential real estate and income producing commercial properties.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above and is required in instances, which the Company deems necessary.

35

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

13. Commitments and Contingencies, continued

Concentrations of Credit Risk

The majority of the Company’s loans, commitments to extend credit, and standby letters of credit have been granted to customers in the Company’s market area. The majority of such customers are depositors of the Bank. Investments in state and municipal securities involve governmental entities within and outside the Company’s market area. The concentrations of credit by type of loan are set forth in the Loans Receivable note. The distribution of commitments to extend credit approximates the distribution of loans outstanding. Standby letters of credit are granted primarily to commercial borrowers. The Company, as a matter of policy, does not extend credit to any single borrower or group of related borrowers in excess of approximately $2.7 million.

Although the Company has a reasonably diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent upon economic conditions in and around Floyd, Carroll, Montgomery, Roanoke and Pulaski Counties and the Cities of Roanoke, Salem and Fairlawn, Virginia. A significant amount of the real estate loans set forth in the Loans Receivable note are secured by commercial real estate. The Company has a loan concentration relating to nonresidential buildings and real estate land developers. Total loans to this group amounted to approximately $32.5 million at December 31, 2009 and approximately $31.4 million at December 31, 2008. In addition, the Company has loan concentrations relating to hotels and motels. Total loans to this group amounted to approximately $15.0 million at December 31, 2009 and approximately $15.5 million at December 31, 2008.

The Company has cash and cash equivalents on deposit with financial institutions which exceed federally insured limits.

Note 14. Regulatory Matters

Dividends

The Company’s dividend payments are made from dividends received from the Bank. The Bank, as a Virginia banking corporation, may pay dividends only out of its retained earnings. However, regulatory authorities may limit payment of dividends by any bank when it is determined that such a limitation is in the public interest and is necessary to ensure financial soundness of the Bank.

Intercompany Transactions

The Bank’s legal lending limit on loans to the Company are governed by Federal Reserve Act 23A, and differ from legal lending limits on loans to external customers. Generally, a bank may lend up to 10% of its capital and surplus to its Parent, if the loan is secured. If collateral is in the form of stocks, bonds, debentures or similar obligations, it must have a market value when the loan is made of at least 20% more than the amount of the loan, and if obligations of a state or political subdivision or agency thereof, it must have a market value of at least 10% more than the amount of the loan. If such loans are secured by obligations of the United States or agencies thereof, or by notes, drafts, bills of exchange or bankers’ acceptances eligible for rediscount or purchase by a Federal Reserve Bank, requirements for collateral in excess of the loan amount do not apply. Under this definition, the legal lending limit for the Bank on loans to the Company was approximately $2.0 million at December 31, 2009. There were no intercompany loans at December 31, 2009 and 2008, respectively.

36

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 14. Regulatory Matters, continued

Capital Requirements

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2009 and 2008, that the Company and the Bank met all capital adequacy requirements to which they are subject.

As of December 31, 2009, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category.

37

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 14. Regulatory Matters, continued

Capital Requirements, continued

The Company and the Bank’s actual capital amounts and ratios are also presented in the following table.

	Actual				Minimum For Capital Adequacy Purposes				Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
In thousands	Amount		Ratio		Amount		Ratio		Amount		Ratio
December 31, 2009
Total capital to risk-weighted assets
Consolidated	$	33,079	19.94	%	$	13,269	8.00	%		n/a	n/a
Bank of Floyd		22,094	14.16	%		12,483	8.00	%	$	15,604	10.00	%
Tier I capital to risk-weighted assets
Consolidated		30,998	18.69	%		6,634	4.00	%		n/a	n/a
Bank of Floyd		20,139	12.91	%		6,241	4.00	%		9,362	6.00	%
Tier I capital to average assets
Consolidated		30,998	13.46	%		9,209	4.00	%		n/a	n/a
Bank of Floyd		20,139	8.82	%		9,130	4.00	%		11,412	5.00	%
December 31, 2008
Total capital to risk-weighted assets
Consolidated	$	32,352	19.90	%	$	13,003	8.00	%		n/a	n/a
Bank of Floyd		20,755	13.73	%		12,096	8.00	%	$	15,120	10.00	%
Tier I capital to risk-weighted assets
Consolidated		30,693	18.88	%		6,501	4.00	%		n/a	n/a
Bank of Floyd		19,247	12.73	%		6,048	4.00	%		9,072	6.00	%
Tier I capital to average assets
Consolidated		30,693	14.04	%		8,742	4.00	%		n/a	n/a
Bank of Floyd		19,247	9.04	%		8,189	4.00	%		10,237	5.00	%

Note 15. Transactions with Related Parties

The Company has entered into transactions with its directors, significant shareholders and their affiliates (related parties). Such transactions were made in the ordinary course of business on substantially the same terms and conditions, including interest rates and collateral, as those prevailing at the same time for comparable transactions with other customers, and did not, in the opinion of management, involve more than normal credit risk or present other unfavorable features.

Aggregate loan transactions with related parties were as follows:

December 31, (In thousands)	2009			2008
Balance, beginning	$	522		$	527
Additions		311			146
Repayments		(350	)		(151	)
Balance, ending	$	483		$	522

38

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 15. Transactions with Related Parties, continued

Deposit transactions with related parties at December 31, 2009 and 2008 were insignificant.

Note 16. Parent Company Financial Information

Condensed financial information of Cardinal Bankshares Corporation is presented as follows:

Balance Sheets

December 31, (In thousands)	2009			2008
Assets
Cash and due from banks	$	1,222		$	263
Investment securities available for sale, at fair value		2,070			2,103
Total loans		7,540			9,340
Allowance for loan losses		(342	)		(151	)
Net loans		7,198			9,189
Investment in affiliate bank at equity		19,979			18,109
Other assets		239			182
Total assets	$	30,708		$	29,846
Liabilities
Other liabilities	$	—		$	400
Total liabilities		—			400
Stockholders’ equity
Common stock		15,357			15,357
Additional paid-in capital		2,925			2,925
Retained earnings		12,716			12,411
Accumulated other comprehensive loss		(290	)		(1,247	)
Total stockholders’ equity		30,708			29,446
Total liabilities and stockholders’ equity	$	30,708		$	29,846

39

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 16. Parent Company Financial Information, continued

Statements of Income

Years ended December 31, (In thousands)	2009			2008
Income
Dividends from affiliate bank	$	—		$	445
Interest on loans		480			641
Interest on investment securities		138			131
Other income		20			10
Total income		638			1,227
Expenses
Management and professional fees		443			612
Provision for loan losses		191			46
Other expenses		69			69
Total expenses		703			727
Income (loss) before income tax (expense) benefit and equity in undistributed net income of subsidiaries		(65	)		500
Income tax (expense) benefit		23			(16	)
Income (loss) before equity in undistributed net income of subsidiaries		(42	)		484
Equity in undistributed net income of subsidiaries		593			1,075
Net income	$	551		$	1,559

40

Cardinal Bankshares Corporation and Subsidiaries

Notes to Consolidated Financial Statements

Note 16. Parent Company Financial Information, continued

Statements of Cash Flows

Years ended December 31, (In thousands)	2009			2008
Cash flows from operating activities
Net income	$	551		$	1,559
Adjustments to reconcile net income to net cash (used) provided by operating activities:
Accretion of discount on securities, net of amortization of premiums		3			3
Provision for loan losses		191			46
Equity in undistributed income of subsidiaries		(593	)		(1,075	)
Net change in other assets		(347	)		596
Net change in other liabilities		(400	)		400
Net cash (used) provided by operating activities		(595	)		1,529
Cash flows from investing activities
Net decrease (increase) in loans		1,800			(486	)
Purchases of investment securities		—			(817	)
Net cash (used) provided by investing activities		1,800			(1,303	)
Cash flows from financing activities
Dividends paid		(246	)		(937	)
Net cash used by financing activities		(246	)		(937	)
Net increase (decrease) in cash and cash equivalents		959			(711	)
Cash and cash equivalents, beginning		263			974
Cash and cash equivalents, ending	$	1,222		$	263

Note 17. Subsequent Events

The Tanglewood branch of the Bank, located at 4309 Starkey Road, Roanoke, Virginia 24018, was closed effective March 19, 2010 due to the inability to achieve consistent profitability.

41

Management’s Discussion and Analysis

Overview

Management’s Discussion and Analysis is provided to assist in the understanding and evaluation of Cardinal Bankshares Corporation’s financial condition and its results of operations. The following discussion should be read in conjunction with the Corporation’s consolidated financial statements. Certain previously reported amounts have been reclassified to conform to current presentations.

Cardinal Bankshares Corporation, the parent company of Bank of Floyd, currently operates seven offices in Floyd, Montgomery, Roanoke, Carroll and Pulaski Counties of Virginia. The main office is in Floyd with a limited service office in Willis. The Roanoke office is in the Cave Spring area of Roanoke County. The West Salem office is located on West Main Street in Salem, Virginia. The Hillsville office is located in Carroll County on Route 52 in Hillsville, Virginia. Montgomery County is served by the branch in Christiansburg, Virginia. The Pulaski County office is located in the Fairlawn community. The Roanoke office in the Tanglewood Mall area of Roanoke County was closed on March 19, 2010 due to consistent operating deficits.

The individual market conditions of each county vary from rural to urban with Floyd County being the most rural and Roanoke the most urban. Each has its own growth pattern which varies in intensity. Bank of Floyd and bank personnel work with local, state and federal government leaders in an effort to attract business and industry to Floyd County.

Cardinal Bankshares reported net income for the year 2009 of $551 thousand, significantly lower than the $1.6 million reported in 2008. The primary factors contributing to the decline in net income were the continued historically low rate of 0.00% to 0.25% paid on overnight fed funds throughout the year; FDIC premiums paid of $1.6 million, of which $466 thousand was expensed, representing an increase of $440 thousand over the previous year; and additions to the Allowance for Loan Losses of $1.2 million. Net income per diluted share was $.36, $.65 lower than the $1.01 reported for the prior year.

Net interest income, on a taxable equivalent basis, was $6.5 million, lower by $500 thousand from $7.0 million in 2008. This decrease was driven primarily by the continuation of historically low rates of 0.00%—0.25%, paid throughout 2009, on fed funds on overnight deposits included in Deposits in Other Banks. Noninterest income decreased by 14.5% to $654 thousand for 2009 compared to $765 thousand for 2008. The decrease in Noninterest income was attributable to a decrease in earnings on Bank Owned Life Insurance and a reimbursement for $69 thousand received in 2008 from the Commonwealt of Virginia for construction of the Fairlawn branch. Noninterest expense decreased $200 thousand to $5.1 million compared to $5.3 million in 2008. This decrease is attributable to a reversal of pension liability in the amount of $667 thousand due to a change in accounting for the pension plan.

Earning assets averaged $217.4 million, compared to $202.1 million in 2008, due to increases in Federal funds sold of $15.7 million and loans of $11.4 million. Average securities decreased $1.8 million in 2009, due largely to early calls in an effort by security issuers to take advantage of declining interest rates.

Interest-bearing liabilities averaged $172.2 million, compared to $155.6 million in 2008 driven by increases of $5.7 million in Savings deposits, $5.4 million in Time deposits and $5.3 million in Large denomination deposits. The increase in interest-bearing liabilities reflects the shift of funds from higher risk investments to an environment of less risk and greater stability.

Stockholders’ equity decreased 1.4% to an average of $29.7 million in 2009 from $30.1 million in 2008. The return on average assets and average equity decreased to .24% and 1.85%, respectively for 2009 compared to .72% and 5.17%, respectively, for 2008. Book value per share was $20.00 at December 31, 2009, compared to $19.17 at year-end 2008, representing an increase of 4.3%.

42

Management’s Discussion and Analysis

Table 1. Average Balances and Interest Rates (Taxable Equivalent Basis)

Years ended December 31, (In thousands)	2009							2008							2007
	Average Balance			Interest Income/ Expense		Yield/ Cost		Average Balance			Interest Income/ Expense		Yield/ Cost		Average Balance			Interest Income/ Expense		Yield/ Cost
Assets:
Interest-earning assets:
Deposits in other banks	$	1,627		$	2	.11	%	$	11,713		$	271	2.31	%	$	25,005		$	1,272	5.09	%
Taxable investment securities		25,729			1,166	4.53	%		25,461			1,395	5.48	%		22,941			1,223	5.33	%
Nontaxable investment securities		18,619			1,170	6.28	%		20,654			1,328	6.43	%		20,740			1,192	5.75	%
Federal funds sold		24,322			49	.20	%		8,589			171	1.99	%		8,815			443	5.02	%
Loans (3), (4)		147,060			9,138	6.21	%		135,731			9,539	7.03	%		120,432			9,165	7.61	%
Total interest-earning assets		217,357			11,525	5.30	%		202,148			12,704	6.28	%		197,933			13,295	6.72	%
Noninterest-earning assets:
Cash and due from banks		3,560							3,245							3,427
Premises and equipment		3,905							4,135							4,299
Other assets		7,700							8,008							7,827
Allowance for loan losses		(1,807	)						(1,654	)						(1,677	)
Total assets	$	230,715						$	215,882						$	211,809
Liabilities and stockholders’ equity:
Interest-bearing liabilities:
Interest checking	$	10,696			53	0.49	%	$	10,516			48	0.46	%	$	10,478			41	0.39	%
Savings deposits		30,192			431	1.43	%		24,500			402	1.64	%		23,944			403	1.68	%
Time deposits		78,465			2,894	3.69	%		73,091			3,258	4.46	%		79,757			3,789	4.75	%
Large denomination deposits		52,802			1,659	3.13	%		47,453			1,979	4.17	%		37,084			1,659	4.46	%
Securities sold under agreements to repurchase		—			—	0.00	%		—			—	0.00	%		—			—	0.00	%
Total interest-bearing liabilities		172,155			5,037	2.93	%		155,560			5,687	3.66	%		151,263			5,892	3.90	%
Noninterest-bearing liabilities:
Demand deposits		27,220							28,420							28,710
Other liabilities		1,617							1,765							2,522
Total liabilities		200,992							185,745							182,495
Stockholders’ equity		29,723							30,137							29,314
Total liabilities and stockholders’ equity	$	230,715						$	215,882						$	211,809
Net interest earnings				$	6,488						$	7,017						$	7,403
Net interest spread (1)						2.37	%						2.62	%						2.82	%
Net interest margin (2)						2.99	%						3.47	%						3.74	%
Taxable equivalent adjustment				$	541						$	535						$	337

(1) Net interest spread is the difference between the average interest rate received on earning assets and the average interest rate paid for interest-bearing liabilities.

(2) Net interest margin is calculated by dividing taxable equivalent net interest earnings by total average earning assets.

(3) Average loan balances include nonaccrual loans.

(4) Interest income includes deferred loan fees.

43

Management’s Discussion and Analysis

Net Interest Income

Net interest income, the primary source of the Company’s earnings, is the amount by which interest and fee income generated by earning assets exceeds the interest paid on interest-bearing liabilities. Earning assets are comprised of loans, securities, federal funds sold and interest-bearing deposits in other banks. Interest-bearing liabilities consist of deposits, federal funds purchased and securities sold under agreements to repurchase. The volume and the general level of interest rates among earning assets and interest-bearing liabilities effect net interest income. Table 1 shows the average balance sheets for each of the years ended December 31, 2009, 2008 and 2007. In addition, the amounts of interest earned on earning assets, with related yields, and the interest paid on interest-bearing liabilities, together with rates, are shown. Loans placed on a nonaccrual status are included in the balances and were included in the computation of yields, upon which they had an immaterial effect. Interest on earning assets is on a taxable equivalent basis, which is computed using the federal corporate income tax rate of 34% for all three years.

Net interest income, on a taxable equivalent basis, was $6.5 million, a decrease of 7.5%, or $529 thousand from the $7.0 million in 2008. The net interest margin was 2.99% for 2009, down 48 basis points from the 3.47% reported in 2008.

As illustrated in Table 2, the effect of decreased rates affecting the Company’s total interest earning assets is evident in the $661 thousand decrease in interest income due primarily to rate.

During 2009, average interest bearing liabilities expense decreased by $656 thousand due to decreased rates paid on deposits.

Table 2. Rate/Volume Variance Analysis

	2009 Compared to 2008									2008 Compared to 2007
				Increase (Decrease) Due To									Increase (Decrease) Due To
December 31, (In thousands)	Total			Rate			Volume			Total			Rate			Volume
Interest-earning assets:
Deposits in other banks	$	(269	)	$	(36	)	$	(233	)	$	(1,001	)	$	(325	)	$	(676	)
Taxable investment securities		(229	)		(244	)		15			172			38			134
Nontaxable investment securities		(158	)		(27	)		(131	)		136			141			(5	)
Federal funds sold		(122	)		(435	)		313			(272	)		(261	)		(11	)
Loans		(401	)		(1,197	)		796			374			(790	)		1,164
Total		(1,179	)		(1,939	)		760			(591	)		(1,197	)		606
Interest-bearing liabilities:
Interest checking		5			4			1			7			7			—
Savings deposits		29			(64	)		93			(1	)		(10	)		9
Time deposits		(364	)		(604	)		240			(531	)		(214	)		(317	)
Large denomination deposits		(320	)		(543	)		223			320			(144	)		464
Securities sold under agreements to repurchase		—			—			—			—			—			—
Total		(650	)		(1,207	)		557			(205	)		(361	)		156
Net interest income	$	(529	)	$	(732	)	$	203		$	(386	)	$	(836	)	$	450

44

Management’s Discussion and Analysis

Provision for Loan Losses

The allowance for loan losses represents the amount available for credit losses inherent in the Company’s loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. Management determines the provision for loan losses required to maintain an allowance adequate to provide for any potential losses. The factors considered in making this decision are the collectibility of past due loans, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of underlying collateral and general economic trends. In 2009, the provision for loan losses was $1.2 million, an increase of $1.1 million from the $94 thousand recorded in 2008. Based upon management’s periodic reviews of the loan portfolio using the previously mentioned factors, the current year increase in the provision for loan losses was felt appropriate. Management believes the provision recorded in 2009 maintains the allowance at a level adequate to cover potential losses. The allowance for loan losses as a percentage of total loans was 1.78% at year-end. This level is greater than the 1.42% ratio averaged at year-end 2009 by the Company’s peer group, commercial banks with assets ranging between $100 million and $300 million. Loan charge-offs exceeded loan recoveries by $215 thousand for 2009, compared to loan charge-offs net of recoveries of $104 thousand for 2008. Management does not anticipate any material changes in the delinquency rates or charge-offs and recoveries in connection with its normal lending activities.

Additional information regarding the Company’s allowance for loan losses is contained in Tables 13 and 14, and in the discussion concerning Analysis of the Allowance for Loan Losses.

Noninterest Income

Noninterest income consists of revenues generated from a number of different financial services and activities. Service charges on deposit accounts including charges for insufficient funds items and fees charged for nondeposit services make up a significant portion of noninterest income. Noninterest income also includes fees charged for services such as safe deposit box rentals, letters of credit, and gains realized on the sale of securities. Noninterest income totaled $654 thousand in 2009, a decrease of $111 thousand under the $765 thousand recorded in 2008. The largest decreases in noninterest income resulted from a decrease of $30 thousand in income on bank owned life insurance (BOLI) due to the assets in the plan generating a significantly reduced return as a result of the declining economy and a $77 thousand decrease in Other income due to decreased dividend income from the FBC subsidary and insurance proceeds of $40 thousand received in 2008 due to the death of a former bank director. The primary sources of noninterest income for the past three years are summarized in Table 3.

Table 3. Noninterest Income

Year ended December 31, (In thousands)	2009		2008		2007
Deposit fees and charges	$	186	$	208	$	224
Other service charges and fees		113		106		103
Gain on the sale of securities		50		39		56
Bank owned life insurance		164		194		377
Other income		141		218		215
Total noninterest income	$	654	$	765	$	975

45

Management’s Discussion and Analysis

Noninterest Expense

Noninterest expense was $5.1 million for 2009, a decrease of $255 thousand from the $5.3 million recorded in 2008. Salaries and employe benefits accounted for the decrease due to a change in accounting method for the pension plan creating a reversal of pension liability resulting in an income effect of $667 thousand, which offset the $440 thousand increase in FDIC premium. Legal and professional fees decreased $140 thousand due to the final disposition of the Welch case. Bank franchise tax showed an increase of $74 thousand due to reimbursement of $69 thousand received in 2008 from the Commonwealth of Virginia for the construction of the Fairlawn branch. Data processing decreased $45 thousand due to the expiration of certain maintenance contracts which were not renewed due to the pending upgrade of the computer system.

The FDIC levied a one-time special assessment based on the June 30, 2009 Call Report, payable on September 30, 2009, totaling $101 thousand and levied a 39-month prepayment based on the September 30, 2009 Call Report, payable on December 30, 2009, totaling $1.3 million, of which $1.2 million was classified as prepaid and $165 thousand was expensed in 2009. In addition, during the course of the year, the annual assessment rate levied on deposits was increased from 6.51 to 15.57 basis points per $10 thousand of deposits even though the bank maintained its overall rating.

Table 4 provides a further breakdown of noninterest expense for the past three years.

Table 4. Noninterest Expense

Year ended December 31, (In thousands)	2009		2008		2007
Salaries and employee benefits	$	2,777	$	3,271	$	3,191
Occupancy and equipment		640		724		697
Legal and professional		256		396		410
Bank franchise tax		141		67		131
Data processing services		186		231		158
FDIC insurance premiums		466		26		21
Foreclosed assets, net		1		—		3
Other operating expense		622		629		675
Total noninterest expense	$	5,089	$	5,344	$	5,286

Income Taxes

Income tax expense is based on amounts reported in the statements of income, after adjustments for non-taxable income and non-deductible expenses, and consists of taxes currently due plus deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. The deferred tax assets and liabilities represent the future Federal income tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled.

Income tax expense, substantially all Federal, was $(265) thousand in 2009, $250 thousand in 2008 and $517 thousand in 2007 representing 92.7%, 13.8 % and 18.6% of income before income taxes, respectively. Cardinal Bankshares’ deferred income tax benefits and liabilities result primarily from temporary differences in provisions for credit losses, valuation reserves, depreciation, deferred compensation, deferred income, pension expense and investment security discount accretion.

Net deferred income tax benefits of approximately $1.5 million and $1.6 million at December 31, 2009 and 2008, respectively, are included in other assets.

46

Management’s Discussion and Analysis

Earning Assets

In 2009, average earning assets increased to $217.4 million, $15.3 million higher than the 2008 average of $202.1 million. Total average earning assets represented 94.2% of total average assets in 2009. Average investment securities accounted for 19.2% of total average assets, while average loans remained the largest component of earning assets, accounting for 63.7% of total average assets in 2009, up from the 62.9% level reported in 2008. A summary of average assets for the past three years is shown below in Table 5.

Table 5. Average Asset Mix

December 31, (In thousands)	2009			2008			2007
	Average Balance		%	Average Balance		%	Average Balance		%
Interest-earning assets:
Loans	$	147,060	63.7	$	135,731	62.9	$	120,432	56.9
Investment securities		44,348	19.2		46,115	21.4		43,681	20.6
Federal funds sold		24,322	10.5		8,589	3.9		8,815	4.2
Deposits in other banks		1,627	0.8		11,713	5.4		25,005	11.8
Total interest-earning assets		217,357	94.2		202,148	93.6		197,933	93.5
Noninterest-earning assets:
Cash and due from banks		3,560	1.5		3,245	1.5		3,427	1.6
Premises and equipment		3,905	1.7		4,135	1.9		4,299	2.0
Other assets		5,893	2.6		6,354	3.0		6,150	2.9
Total noninterest-earning assets		13,358	5.8		13,734	6.4		13,876	6.5
Total assets	$	230,715	100.0	$	215,882	100.0	$	211,809	100.0

Loans

Average total loans were $147.1 million for 2009, an increase of $11.4 million, or 8.3% from 2008. At December 31, 2009, the actual balance of loans secured by real estate represented the most significant portion of the loan portfolio at 88.2%. Total loans secured by 1-4 family residential properties represented 20.0% of total loans at the end of 2009, while nonfarm/nonresidential properties made up 53.8% of total loans. .

Loan growth will continue to be a point of focus at Cardinal for 2009. The long-range strategic objective for meeting the Company’s loan growth aspirations will be achieved through continued hiring of additional loan officers, community involvement, expansion of the Company’s market footprint, broadening of the present array of loan products offered to include conforming fixed-rate mortgage loans, home equity lines of credit and SBA loans, and management’s strengthened efforts in offering small business financing and competively-priced products. Prudent business practices and stringent internal guidelines will continue to be followed in making lending decisions in order to balance the emphasis on loan growth with the desire to minimize exposure to loan losses.

Bank of Floyd makes both consumer and commercial loans to all neighborhoods within its market area, including the low-income and moderate-income areas. The Company’s market area is generally defined as the areas within the Virginia Counties of Floyd, Roanoke, Montgomery, Carroll and Pulaski and the Cities of Roanoke, Salem, Christiansburg and Fairlawn, Virginia. The Bank places emphasis on consumer based installment loans and commercial loans to small and medium sized businesses. Below market pricing, competition from unregulated organizations and a weak economy have also been a factor when generating new loans. The amounts of loans outstanding by type at year-end 2009 and 2008, and the maturity distribution of variable and fixed rate loans as of year-end 2009 are presented below in Table 6 and Table 7, respectively.

47

Management’s Discussion and Analysis

Loans, continued

During 2009 gross loans increased $2.2 million, with the Nonfarm, nonresidential accounting for virtually all growth while offsetting declines in other categories. The nonfarm, nonresidential category increased due to strong demand for loans from businesses using real estate as collateral.

Table 6. Loan Portfolio Summary

December 31, (In thousands)	2009					2008					2007					2006					2005
	Amount			%		Amount			%		Amount			%		Amount			%		Amount			%
Real estate construction and development	$	17,441		11.6		$	19,735		13.3		$	19,168		15.4		$	11,362		9.2		$	11,770		9.1
Farmland		1,264		.8			2,089		1.4			3,362		2.7			3,077		2.5			3,118		2.4
Real estate mortgage:
1-4 family residential		30,039		20.0			28,671		19.4			23,584		19.0			23,441		19.1			27,943		21.5
Multifamily residential		3,047		2.0			2,978		2.0			1,761		1.4			1,858		1.5			1,867		1.4
Nonfarm, nonresidential		80,708		53.8			73,820		49.9			62,781		50.5			71,650		58.3			73,385		56.4
Total real estate		132,499		88.2			127,293		86.0			110,656		89.0			111,388		90.6			118,083		90.8
Agricultural		148		0.1			183		0.1			384		0.3			675		0.5			795		0.6
Commercial and industrial		7,675		5.1			7,914		5.4			6,632		5.3			5,664		4.6			8,864		6.8
Consumer		3,117		2.1			3,937		2.7			3,836		3.1			2,135		1.7			2,552		2.0
Other loans		6,992		4.7			8,914		6.0			3,258		2.6			3,408		2.8			32		0.0
Leases		—		0.0			—		0.0			—		0.0			—		0.0			—		0.0
Gross loans		150,431					148,241					124,766					123,270					130,326
Unearned income		(350	)	(0.2	)		(320	)	(0.2	)		(314	)	(0.3	)		(296	)	(0.2	)		(345	)	(0.2	)
Total	$	150,081		100.0		$	147,921		100.0		$	124,452		100.0		$	122,974		100.0		$	129,981		100.0

Table 7. Loan Maturity Schedule

	2009
December 31, (In thousands)	Commercial Financial and Agricultural		Construction and Development		Others		Total Amount		%
Fixed rate loans:
Within three months	$	661	$	2,352	$	1,477	$	4,490	3.0
After three but within twelve months		817		1,502		14,159		16,478	11.0
After one but within five years		1,442		3,954		14,202		19,598	13.0
Over five years		396		172		44,783		45,351	30.1
Total fixed rate loans		3,316		7,980		74,621		85,917	57.1
Variable rate loans:
Within three months		4,299		7,146		5,551		16,996	11.3
After three but within twelve months		208		—		8,067		8,275	5.5
After one but within five years		—		2,191		30,829		33,020	22.0
Over five years		—		124		6,099		6,223	4.1
Total variable rate loans		4,507		9,461		50,546		64,514	42.9
Total loans:
Within three months		4,960		9,498		7,028		21,486	14.3
After three but within twelve months		1,025		1,502		22,226		24,753	16.5
After one but within five years		1,442		6,145		45,031		52,618	35.0
Over five years		396		296		50,882		51,574	34.2
Total loans	$	7,823	$	17,441	$	125,167	$	150,431	100.0

48

Management’s Discussion and Analysis

Investment Securities

The investment securities portfolio is managed to optimize the yield on excess funds while providing liquidity for unexpected deposit decreases or increased loan generation and diversification in the overall asset management of the Company. At December 31, 2009, the Company had $36.7 million in securities available for sale, compared to $28.9 million at year-end 2008. The average yield on taxable investment securities decreased from 5.48% in 2008 to 4.53% in 2009 as a result of lower yielding securities and decreasing market rates of interest.

Management of the investment portfolio has always been conservative with virtually all investments taking the form of purchases of U.S. Treasury, Government Sponsored Enterprises, Mortgage Backed Securities and issuances of State and local bond issues. All securities are high quality and high grade. Management views the investment portfolio as a source of income, and generally purchases securities with the intent of retaining them until maturity. However, adjustments in the portfolio are necessary from time to time to provide a source of liquidity to meet funding requirements for loan demand, deposit fluctuations and to manage interest rate risk. Accordingly, to meet such objectives, management may sell certain securities prior to their scheduled maturity. Table 8 presents the investment portfolio at the end of 2009 by major types of investments and maturity ranges. Actual maturities may differ from scheduled maturities in mortgage backed securities because the mortgages underlying the securities may be called or repaid prior to the scheduled maturity date. Maturities on all other securities are based on the earlier of the contractual maturity or the call date, if any.

At December 31, 2009, the market value of the investment portfolio was $52.8 million, representing a $236 thousand unrealized loss below amortized cost.

At December 31, 2008, the market value of the investment portfolio was $45.5 million, representing a $638 thousand unrealized loss below amortized cost. This compared to a market value of $45.4 million and a $17 thousand unrealized loss below amortized cost a year earlier.

Table 8. Investment Securities

December 31, 2009 (In thousands)	Amortized Cost Due
	Due Within One Year			After One Through Five Years			After Five Through Ten Years			After Ten Years			Total			Market Value
Investment securities
Government sponsored enterprises and mortgage backed securities	$	—		$	122		$	3,572		$	26,744		$	30,438		$	30,551
State and political subdivisions		864			5,804			6,483			5,344			18,495			18,736
Other securities		—			795			500			2,761			4,056			3,466
Total	$	864		$	6,721		$	10,555		$	34,849		$	52,989		$	52,753
Weighted average yields
Government sponsored enterprises and mortgage backed securities		—	%		5.63	%		3.49	%		4.20	%
State and political subdivisions		4.38	%		3.86	%		4.30	%		4.42	%
Other securities		—	%		5.32	%		1.82	%		6.53	%
Total securities		4.38	%		4.07	%		3.91	%		4.39	%		4.25	%

December 31, 2008 (In thousands)	Book Value		Market Value
Investment securities
Government sponsored enterprises and mortgage backed securities	$	22,713	$	22,761
States and political subdivisions		19,386		19,548
Other securities		4,049		3,201
Total	$	46,148	$	45,510

49

Management’s Discussion and Analysis

December 31, 2007 (In thousands)	Book Value		Market Value
Investment securities
Government sponsored enterprises and mortgage backed securities	$	22,132	$	21,919
States and political subdivisions		21,862		22,013
Other securities		1,455		1,500
Total	$	45,449	$	45,432

Deposits

Cardinal Bankshares relies on deposits generated in its market area to provide the majority of funds needed to support lending activities and for investments in liquid assets. More specifically, core deposits (total deposits less certificates of deposits in denominations of $100,000 or more) are the primary funding source. The Company’s balance sheet growth is largely determined by the availability of deposits in the markets it serves, the cost of attracting the deposits, and the prospects of profitably utilizing the available deposits by increasing the loan or investment portfolios. The sustained low interest rate environment, coupled with an ever weakening economy and historic losses being posted by large banks have resulted in depositors shifting their emphasis from rate shopping to banks which offer soundness and security. Increased customer awareness of interest rates has added to the importance of effective interest rate management. Accordingly, management must continuously monitor market pricing and internal interest rate spreads to continue the Company’s growth and improve profitability. Cardinal Bankshares’ interest rate management goals include structuring rates in a manner that can promote both deposit and asset growth while increasing overall profitability of the Company.

Average total deposits for the year ended December 31, 2009 increased $15.4 million to $199.4 million compared to 2008. As shown in Table 9, the Company’s average interest-bearing deposits as a percent of total average deposits increased to 86.3% in 2009, compared to 84.6% in 2008. Average noninterest-bearing demand deposits decreased to $27.2 million in 2009 from $28.4 million in 2008. Average deposits for the past three years are summarized in Table 9 below.

Table 9. Deposit Mix

December 31, (In thousands)	2009			2008			2007
	Average Balance		%	Average Balance		%	Average Balance		%
Interest-bearing deposits:
Interest checking	$	10,696	5.4	$	10,516	5.7	$	10,478	5.8
Money Market		11,249	5.6		6,720	3.7		4,794	2.7
Savings deposits		18,943	9.5		17,780	9.7		19,150	10.6
Time deposits		78,465	39.3		73,091	39.7		79,757	44.3
Large denomination deposits		52,802	26.5		47,453	25.8		37,084	20.6
Total interest-bearing deposits		172,155	86.3		155,560	84.6		151,263	84.0
Noninterest-bearing deposits		27,220	13.7		28,420	15.4		28,710	16.0
Total deposits	$	199,375	100.0	$	183,980	100.0	$	179,973	100.0

The average balance of certificates of deposit issued in denominations of $100,000 or more increased by approximately $5.3 million in 2009. Table 10 provides maturity information relating to Certificates of Deposit of $100,000 or more at December 31, 2009.

50

Management’s Discussion and Analysis

Table 10. Large Denomination Deposits $100,000 and Over

Analysis of time deposits of $100,000 or more at December 31, 2009 (In thousands):

Time remaining to maturity:
Less than three months	$	7,321
Three months through one year		35,364
Over one year		20,039
Total time deposits of $100,000 or more	$	62,724

Capital Adequacy

The Company’s capital serves to support asset growth and provide protection against loss to depositors and creditors. Cardinal Bankshares strives to maintain an optimum level of capital, commensurate with its risk profile, on which an attractive return to stockholders can be realized over both the near and long term, while serving depositors’, creditors’ and regulatory needs.

Common stock, capital surplus and retained earnings net of dividends represent the stockholders’ investment in the Company and are a key source of capital. Total stockholders’ equity was $30.7 million at December 31, 2009, an increase of $1.3 million or 4.4% compared with $29.4 million for the same period in 2008. This increase relates to the change in Accumulated other comprehensive income of approximately $957 thousand consisting of reversal of pension costs due to change in accounting for pension liability and unrealized losses on available for sale securities.

The FDIC has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0% of which at least 4.0% must be Tier 1 capital, composed of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain goodwill items. Cardinal Bankshares had a ratio of total capital to risk-weighted assets of 19.94% at December 31, 2009 and a ratio of Tier 1 capital to risk-weighted assets of 18.69%. Both of these ratios well exceed the capital requirements adopted by the federal regulatory agencies and continue to be equal to or above most of our peer group.

In addition, a minimum leverage ratio of Tier I capital to average total assets for the previous quarter is required by federal bank regulators, ranging from 3% to 5%, subject to the regulator’s evaluation of the Company’s overall safety and soundness. As of December 31, 2009, Cardinal Bankshares had a ratio of year-end Tier I capital to average total assets, as defined, of 13.46%.

Table 11 below sets forth summary information with respect to the capital ratios for Cardinal and the Bank at December 31, 2009 and 2008. All capital ratio levels indicate that Cardinal Bankshares and Bank of Floyd are well capitalized.

51

Management’s Discussion and Analysis

Table 11. Year-end Risk-based Capital

December 31, (In thousands)	2009						2008
	Consolidated			Bank of Floyd			Consolidated			Bank of Floyd
Tier I capital	$	30,998		$	20,139		$	30,693		$	19,247
Qualifying allowance for loan losses (limited to 1.25% of risk-weighted assets)		2,081			1,955			1,659			1,508
Total regulatory capital	$	33,079		$	22,094		$	32,352		$	20,755
Total risk-weighted assets	$	165.862		$	156,036		$	162,536		$	151,202
Tier I as a percent of risk-weighted assets		18.69	%		12.91	%		18.88	%		12.73	%
Total regulatory capital as a percent of risk- weighted assets		19.94	%		14.16	%		19.90	%		13.73	%
Leverage ratio*		13.46	%		8.82	%		14.04	%		9.40	%

* Tier I capital divided by average total assets for the quarter ended December 31.

Nonperforming and Problem Assets

Certain credit risks are inherent in making loans, particularly commercial and consumer loans. Management prudently assesses these risks and strives to manage them effectively. The Bank seeks to use shorter-term loans and, although a portion of the loans may be made based upon the value of collateral, it relies primarily on the cash flow of the borrower as the source of repayment rather than the value of the collateral.

The Bank also manages its repayment risks by adhering to internal credit policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow-up on exceptions to credit policies.

Nonperforming assets, as shown in Table 12 below, increased to $5.9 million at December 31, 2009 from $3.1 million at December 31, 2008. At year-end 2009, loans past due 90 days or more and still accruing had decreased to $382 thousand from $430 thousand a year earlier. Foreclosed assets decreased to $261 in 2009 from $289 thousand for 2008. Foreclosed assets at the end of 2009 consisted of a mixture of commercial property and residential property listed with an agent to be sold or in the process of being listed. Management does not intend to retain the property.

Table 12. Nonperforming Assets

December 31 (In thousands)	2009		2008		2007		2006		2005
Nonaccrual loans	$	5,302	$	2,405	$	646	$	657	$	—
Loans past due 90 days or more and still accruing		382		430		245		—		49
Foreclosed assets		261		289		212		212		418
Total nonperforming assets	$	5,945	$	3,124	$	1,103	$	869	$	467

52

Management’s Discussion and Analysis

Analysis of the Allowance for Loan Losses

The allowance for loan losses represents the amount available for credit losses inherent in the Company’s loan portfolio. The Company performs periodic systematic reviews of its portfolio to identify these inherent losses, and to assess the overall probability of collection of the portfolio. These reviews result in the identification and quantification of loss factors, which are used in determining the amount of the allowance for loan losses. In addition, the Company also evaluates the prevailing economic and business conditions affecting individual borrowers, changes in the size and characteristics of the loan portfolio and other pertinent factors. The allowance is also subject to annual review by external auditors and regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance, and the size of the allowance in comparison to peer companies identified by regulatory agencies. The most recent regulatory reviews were completed in October 2007 and March 2009.

In addition, management took into account not only the current state of the economy, but information from various sources, which not only expected the current economic downturn to persist, but also expected continued significant losses in commercial real estate. Geographic location was taken into account regarding the depth of economic decline, valuation for certain loans and corresponding collateral. Management also collected additional financial data from certain customers to ascertain current financial strength and cash flow Finally, management maintained the historical overall conservative approach of the Company in calculating additions to the allowance for loan losses.

The Company is committed to the early recognition of problem loans and to a conservative allowance. The Company believes the current allowance is adequate to cover inherent losses in the loan portfolio. However, the allowance may be increased or decreased in the future based upon management’s assessment of the factors outlined above. The allowance for loan losses was $2.7 million at December 31, 2009 and $1.7 million at December 31, 2008. The allowance as a percentage of period end loans was 1.78% at year-end 2009 and 1.12% at year-end 2008.

The provision for loan losses for the year ended December 31, 2009 was $1.2 million, an increase of $1.1 million from the previous year. The loan loss reserve for 2009 increased a total of $1.0 million due to write-offs incurred of $227 thousand less expense to provision of $1.2 million and recoveries of $12 thousand. Based upon management’s periodic reviews of the loan portfolio using the previously mentioned factors, the current year decrease in the provision was considered appropriate. Management believes the provision recorded in 2009 maintains the allowance at a level adequate to cover potential losses.

53

Management’s Discussion and Analysis

The provision for loan losses, net charge-offs and the activity in the allowance for loan losses is detailed in Table 13.

Table 13. Loan Losses

Year ended December 31, (In thousands)	2009		2008		2007			2006			2005
Balance at beginning of year	$	1,659	$	1,669	$	1,640		$	1,427		$	1,631
Provision charged to expense		1,226		94		(19	)		208			48
		2,885		1,763		1,621			1,635			1,679
Loans charged off:
Commercial, financial and agricultural		157		105		—			—			261
Real estate – residential mortgage		67		—		—			3			13
Real estate – construction		—		—		—			—			—
Consumer		3		10		5			24			71
Total charge-offs		227		115		5			27			345
Recoveries of loans previously charged off:
Commercial, financial and agricultural		9		4		43			21			60
Real estate – residential mortgage		—		—		—			—			31
Real estate – construction		—		—		—			—			—
Consumer		3		7		10			11			2
Total recoveries		12		11		53			32			93
Net (recoveries) charge – offs		215		104		(48	)		(5	)		252
Balance at end of year	$	2,670	$	1,659	$	1,669		$	1,640		$	1,427

54

Management’s Discussion and Analysis

The Company has allocated the allowance for loan losses based on estimates of the allowance needed for each component of the loan portfolio. The allocation of the allowance as shown in Table 14 below should not be interpreted as an indication that loan losses in future years will occur in the same proportions or that the allocation indicates future loan loss trends. The specific reserve on impaired loans for 2009 is $1.2 million and that specific reserve is set aside for the impaired loans. Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories since the remaining allowance is a general allowance applicable to the entire portfolio.

Table 14. Allocation of the Allowance for Loan Losses

December 31, (In thousands)	2009			2008			2007			2006			2005
	Amount		%	Amount		%	Amount		%	Amount		%	Amount		%
Balance at end of period applicable to:
Commercial, financial and agricultural	$	623	59.7	$	944	56.6	$	623	58.5	$	702	65.8	$	505	66.0
Real estate, construction		150	11.6		206	13.3		147	15.4		80	9.1		63	9.1
Real estate, residential mortgage		1,762	22.0		392	21.4		822	20.4		794	20.5		845	22.9
Consumer and other loans		135	6.7		117	8.7		77	5.7		64	4.5		14	2.0
Total	$	2,670	100.0	$	1,659	100.0	$	1,669	100.0	$	1,640	100.0	$	1,427	100.0

Liquidity and Interest Rate Sensitivity

The principal goals of the Company’s asset and liability management strategy are the maintenance of adequate liquidity and the management of interest rate risk. Liquidity is the ability to convert assets to cash to fund depositors’ withdrawals or borrowers’ loans without significant loss. Interest rate risk management seeks to balance the effects of interest rate changes on assets that earn interest or liabilities on which interest is paid, to protect the Company from wide fluctuations in its net interest income.

Management must insure that adequate funds are available at all times to meet the needs of its customers. On the asset side of the balance sheet, maturing investments, loan payments, maturing loans, federal funds sold, and unpledged investment securities are principal sources of liquidity. On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates, federal funds lines from correspondent banks, borrowings from the Federal Reserve Bank and the Federal Home Loan Bank, as well as the ability to generate funds through the issuance of long-term debt and equity.

The liquidity ratio, the level of liquid assets divided by total deposits plus short-term liabilities, is considered to be adequate by management.

55

Management’s Discussion and Analysis

Table 15. Interest Rate Sensitivity

��

	December 31, 2009 Maturities/Repricing
(In thousands)	1-3 Months			4-12 Months			13-60 Months			Over 60 Months			Total
Earning Assets:
Loans	$	21,486		$	24,753		$	52,618		$	51,574		$	150,431
Investments		335			529			6,721			45,404			52,989
Interest-bearing deposits in banks		184			—			—			—			184
Federal funds sold		22,175			—			—			—			22,175
Total	$	44,180		$	25,282		$	59,339		$	96,978		$	225,779
Interest-bearing deposits:
Interest checking	$	11,203		$	—		$	—		$	—		$	11,203
Money market		13,909			—			—			—			13,909
Savings		19,497			—			—			—			19,497
Certificates of deposit		15,826			72,484			47,969			19			136,298
Total	$	60,435		$	72,484		$	47,969		$	19		$	180,907
Interest sensitivity gap	$	(16,255	)	$	(47,202	)	$	11,370		$	96,959		$	44,872
Cumulative interest sensitivity gap	$	(16,255	)	$	(63,457	)	$	(52,087	)	$	44,872		$	44,872
Ratio of sensitivity gap to total earning assets		(7.20	)%		(28.11	)%		(23.07	)%		19.87	%		19.87	%

Interest rate risk is the effect that changes in interest rates would have on interest income and interest expense as interest-sensitive assets and interest-sensitive liabilities either reprice or mature. Management attempts to maintain the portfolios of earning assets and interest-bearing liabilities with maturities or repricing opportunities at levels that will afford protection from erosion of net interest margin, to the extent practical, from changes in interest rates. Table 15 above shows the sensitivity of the Company’s balance sheet on December 31, 2009. This table reflects the sensitivity of the balance sheet as of that specific date and is not necessarily indicative of the position on other dates. At December 31, 2009, the Company appeared to be liability-sensitive with interest-bearing liabilities exceeding earning assets, subject to changes in interest rates, for the 1-3, 4-12, and 13-60 months column. The Company in an asset-sensitive position for the Over 60 months periods.

Matching sensitive positions alone does not ensure that Cardinal has no interest rate risk. The repricing characteristics of assets are different from the repricing characteristics of funding sources. Thus, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.

Earnings and Balance Sheet Analysis

2008 Compared to 2007 – Net interest income, on a taxable equivalent basis, was $7.0 million, lower by $386 thousand from $7.4 million in 2007. This decrease was driven primarily by the decrease in average rates paid on the Company’s interest earning deposits. Noninterest income decreased by 21.5% to $765 thousand for 2008 compared to $975 thousand for 2007 primarily due to a decrease in income on bank owned life insurance (BOLI) due to the assets in the plan generating a significantly reduced return as a result of the declining economy. Noninterest expense increased by $58 thousand or 1.1% to $5.3 million compared to $5.3 million in 2007.

Earning assets averaged $202.1 million, compared to $197.9 million in 2007, the increase driven primarily by an overall increase in loans $15.3 million. Average securities increased $2.4 million in 2008. The federal funds sold average balance decreased $226 thousand in 2008.

56

Management’s Discussion and Analysis

Interest-bearing liabilities averaged $155.6 for 2008 compared to $151.3 for 2007 driven primarily by an overall increase in large denomination deposits of $10.4 million. Savings deposits reflected an average increase of $556 thousand from 2007, while average time deposits decreased $6.7 million.

Stockholders’ equity grew 2.8% to an average of $30.1 million in 2008 from $29.3 million in 2007. The return on average assets and average equity decreased to .72% and 5.17%, respectively for 2008 compared to 1.07% and 7.70%, respectively, for 2007. Book value per share was $19.17 at December 31, 2008, compared to $19.48 at year-end 2007, representing a decrease of 1.6%.

The allowance for loan losses at December 31, 2008 was $1.6 million compared to $1.6 million a year earlier. The allowance for loan losses as a percentage of period end loans was 1.12% compared to 1.34% at year-end 2007. The Company had charge-offs, net of recoveries, in the amount of $104 thousand for 2008. This compared to charge-offs, net of recoveries, in the amount of $(48) thousand for 2007. Nonperforming loans totaled $2.4 million at December 31, 2008, an increase of $1.8 million from 2007.

A Warning About Forward-Looking Statements

This annual report contains forward-looking statements. The Company may also make written forward-looking statements in periodic reports to the Securities and Exchange Commission, proxy statements, offering circulars and prospectuses, press releases and other written materials and oral statements made by Cardinal Bankshares’ officers, directors or employees to third parties. Statements that are not historical facts, including statements about the Company’s beliefs and expectations, are forward-looking statements. These statements are based on beliefs and assumptions of the Company’s management, and on information currently available to such management. Forward-looking statements include statements preceded by, followed by or that include the words “believes,” “expects,” “estimates,” “anticipates,” “plans,” or similar expressions. Forward-looking statements speak only as of the date they are made, and the Company undertakes no obligation to update publicly any of them in light of new information or future events.

Forward-looking statements involve inherent risks and uncertainties. Management cautions the readers that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. Such factors include, but are not limited to, the following: competitive pressures among depository and other financial institutions may increase significantly; changes in the interest rate environment may reduce margins; general economic or business conditions may lead to a deterioration in credit quality or a reduced demand for credit; legislative or regulatory changes, including changes in accounting standards, may adversely affect the business in which Cardinal Bankshares is engaged; changes may occur in the securities markets; and competitors of the Company may have greater financial resources and develop products that enable such competitors to compete more successfully than Cardinal Bankshares.

Other factors that may cause actual results to differ from the forward-looking statements include the following: the timely development of competitive new products and services by the Company and the acceptance of such products and services by customers; changes in consumer spending and savings habits; the effects of competitors’ pricing policies; the Company’s success in managing the costs associated with the expansion of existing distribution channels and developing new ones, and in realizing increased revenues from such distribution channels, including cross-selling initiatives; and mergers and acquisitions and their integration into the Company and management’s ability to manage these other risks.

Management of Cardinal Bankshares believes these forward-looking statements are reasonable; however undue reliance should not be placed on such forward-looking statements, which are based on current expectations.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. The future results and stockholder values of Cardinal Bankshares may differ materially from those expressed in forward-looking statements contained in this report. Many of the factors that will determine these results and values are beyond the Company’s ability to control or predict.

57