UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the Quarterly Period Ended September 30, 2004

OR

(  )  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                     to                    

Commission File Number 0-18279

Tri-County Financial Corporation

(301) 843-0854
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   (X)     No (  )

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes (  )    No (X)

As of October 29, 2004 registrant had outstanding 767,859 shares of Common Stock.

TRI-COUNTY FINANCIAL CORPORATION

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PART I. FINANCIAL INFORMATION

See notes to consolidated financial statements

*Share and per share data have been retroactively adjusted to effect a three-for-two common stock split declared on October 22, 2004 as if it had occurred January 1, 2003

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TRI-COUNTY FINANCIAL CORPORATION

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TRI-COUNTY FINANCIAL CORPORATION

*

Share and per share data have been retroactively adjusted to effect a three-for-two common stock split declared on October 22, 2004 as if it had occurred January 1, 2003

See notes to consolidated financial statements.

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TRI-COUNTY FINANCIAL CORPORATION

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TRI-COUNTY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003 continued

See notes to consolidated financial statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

	1.		BASIS OF PRESENTATION
			General - The consolidated financial statements of Tri-County Financial Corporation (the “Company”) and its wholly owned subsidiaries, Community Bank of Tri-County (the “Bank”) and Tri-County Capital Trust I (“Capital Trust I”) , included herein are unaudited; however, they reflect all adjustments consisting only of normal recurring accruals that, in the opinion of Management, are necessary to present fairly the results for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The Company believes that the disclosures are adequate to make the information presented not misleading. The balances as of December 31, 2003 have been derived from audited financial statements. There have been no significant changes to the Company’s accounting policies as disclosed in the 2003 Annual Report. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the results of operations to be expected for the remainder of the year. Certain previously reported amounts have been restated to conform to the 2004 presentation.
			It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes included in the Company’s Annual Report for the year ended December 31, 2003.
	2.		NATURE OF BUSINESS
			The Company, through its bank subsidiary, provides domestic financial services primarily in southern Maryland. The primary financial services include real estate, commercial and consumer lending, as well as demand deposits and savings products.
	3.		INCOME TAXES
			The Company uses the liability method of accounting for income taxes as required by SFAS No. 109, “Accounting for Income Taxes.” Under the liability method, deferred-tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities (i.e., temporary differences) and are measured at the enacted rates that will be in effect when these differences reverse.
	4.		EARNINGS PER SHARE
			Earnings per common share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period, including any potential dilutive common shares outstanding, such as options and warrants. As of September 30, 2004, there were no shares excluded from the diluted net income per share computation because the option price exceeded the average market price and therefore, their effect would be anti-dilutive.
			Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares after giving effect to the three-for-two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2003. Outstanding shares were calculated as follows:

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	5.		STOCK-BASED COMPENSATION
			The Company has adopted the disclosure-only provisions of SFAS No. 123 “Accounting for Stock-Based Compensation,” which encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company’s stock-based plans have no intrinsic value at the grant date, and under Opinion No. 25 no compensation cost is recognized for them. The Company has elected to continue with the accounting methodology in Opinion No. 25. If the Company had elected to recognize compensation cost based on fair value at the grant dates for awards under the Plan consistent with the method prescribed by SFAS No. 123, net income and earnings per share would have been changed to the pro forma amounts as follows for the three and nine months ended September 30.

Basic and diluted earnings per share have been computed based on weighted-average common and common equivalent shares after giving effect to the three-for-two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2003.

6. Guaranteed Preferred Beneficial Interest in Junior Subordinated Debentures

On July 22, 2004, Tri County Capital Trust I (“Capital Trust I”), a Delaware business trust formed, funded and wholly owned by the Company, issued $7,000,000 of variable-rate capital securities with an interest rate of 4.22% in a private pooled transaction. The variable rate is based on the 90-day LIBOR rate plus 2.60%. The Trust used the proceeds from this issuance to purchase $7.2 million of the Company’s junior subordinated debentures. The interest rate on the debentures and the trust preferred securities is variable and adjusts quarterly. The Company has, through various contractual arrangements, fully and unconditionally guaranteed all of Capital Trust I’s obligations with respect to the capital securities. These capital securities qualify as Tier I capital and are presented in the Consolidated Balance Sheets as “Guaranteed Preferred Beneficial Interests in Junior Subordinated Debentures.” Both the capital securities of Capital Trust I and the junior subordinated debentures are scheduled to mature on July 22, 2034, unless called by the Company not earlier than July 22, 2009.

Costs associated with the issuance of the trust-preferred securities were less than $10,000 and were expensed as period costs.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS AND FINANCIAL CONDITION

This document contains forward-looking statements, which it intends to be covered under the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995. Such forward looking statements include discussions of Tri-County Financial Corporation’s (the “Company’s”) goals, strategies and expected outcomes; estimates of risks and future costs; and reports of the Company’s ability to achieve its financial and other goals. These forward-looking statements are subject to significant known and unknown risks and uncertainties because they are based upon future economic conditions, particularly interest rates, competition within and without the banking industry, changes in laws and regulations applicable to the Company and various other matters. Because of these uncertainties, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements.

GENERAL

The Company is a bank holding company organized in 1989 under the laws of the State of Maryland. It presently owns all the outstanding shares of capital stock of Community Bank of Tri-County (the “Bank”), a Maryland-chartered commercial bank and Tri County Capital Trust I (“Capital Trust I”). The Company engages in no significant activity other than holding the stock of the Bank and operating the business of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.

The Bank serves the Southern Maryland area through its main office and eight branches located in Waldorf, Bryans Road, Dunkirk, Leonardtown, La Plata, Charlotte Hall, and California, Maryland. The Bank is engaged in the commercial and retail banking business as authorized by the banking statutes of the State of Maryland and applicable Federal regulations. The Bank accepts demand and time deposits, and originates loans to individuals, associations, partnerships and corporations. The Bank makes real estate loans including residential first and second mortgage loans, construction, home equity lines of credit, commercial mortgages and consumer and commercial business loans. The Bank is a member of the Federal Reserve and Federal Home Loan Bank (“FHLB”) Systems. The Savings Association Insurance Fund (“SAIF”) of the Federal Deposit Insurance Corporation (“FDIC”) provides deposit insurance coverage up to applicable limits.

Since its conversion to a state chartered commercial bank in 1997, the Bank has sought to increase its commercial, commercial real estate, construction, second mortgage, home equity, and consumer lending business as well as the level of transactional deposits to levels consistent with similarly sized commercial banks. As a result of this emphasis, the Bank’s percentage of assets invested in residential first mortgage lending and investment securities has declined since 1997. Conversely, targeted loan types have increased. The Bank has also seen an increase in transactional deposit accounts while the percentage of total liabilities represented by certificates of deposits has also declined. Management believes that these changes will enhance the Bank’s overall long-term financial performance.

Management recognizes that the shift in composition of the Bank’s loan portfolio will tend to increase its exposure to credit losses. The Bank has continued to evaluate its allowance for loan losses and the associated provision to compensate for the increased risk. Any evaluation of the allowance for loan losses is inherently inexact and reflects management’s expectations as to future economic conditions in the Southern Maryland area as well as individual borrower’s circumstances. Management believes that its allowance for loan losses is adequate. For further information on the Bank’s allowance for loan losses see the discussion in the financial condition section of this form, as well as the relevant discussions in the Form 10-K and annual report for the year ended December 31, 2003.

In July 2004, the Company formed a subsidiary that sold $7,000,000 in variable rate capital securities in a private pooled transaction. The proceeds of the sale were invested in the Bank. The Bank leveraged these additional funds by buying securities that it funded primarily with reverse repurchase agreements. These assets provided additional net interest income to the Company that increased net income in the third quarter. The Company recognizes that the purchase of securities in this manner may increase its exposure to a decrease in net interest income should there be a series of interest rate increases. The Company feels that these risks have been considered and that the Company is well positioned to continue this program. It is the Company’s intention to gradually replace the investments and wholesale funding with loans and deposits as the Bank grows.

In the third quarter, the Federal Reserve increased the Federal Funds rate, but the economy continues to grow at a slower pace than anticipated by many economic observers. Locally, the economy is strong and Should Say the recovery appears to be getting stronger the housing market has appreciated in reaction to continued low interest rates and a strong local job market. National job markets also appear to be strengthening. These economic factors have led to an overall consensus that the recovery is now solid and that the Federal Reserve will likely raise rates for the next several quarters. A series of sharp rate increases could negatively impact the Bank’s financial

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performance. This would be particularly true if these rate increases were more rapid and sustained than the corresponding increases in the Bank’s yield on assets. Other negative effects of a sharply higher interest rate environment could include a drop in real estate values. A large sustained drop in real estate values would negatively impact the Bank’s collateral on many of our loans and could lead to asset quality problems.

During the last two years, loan customers have reacted to lower interest rates by continuing to refinance higher rate loans. This refinance activity has decreased the interest rates earned on loans. In the last few quarters longer term rates have increased slightly. These increases will have the effect of decreasing refinance activity. If rates continue to rise, the Bank may also see an increase in the popularity of adjustable rate mortgages in the residential housing market. Higher rates will also decrease prepayments from our investment portfolio. The Bank has been able to increase net interest income from the prior year through growth in its balance sheet, which offset a lower interest margin. Noninterest income decreased primarily due to a reduction in the gain on the sale of loans, offset by an increase in service charges. Noninterest expenses also increased primarily from increases in the Bank’s size. An increase in the valuation allowance on foreclosed real estate also increased expenses. Finally, the effective tax rate paid by the Company decreased due to the donation of certain foreclosed property.

SELECTED FINANCIAL DATA

*All per share amounts have been computed based on weighted-average common and common equivalent shares after giving effect to the three-for-two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2003.

RESULTS OF OPERATIONS

As noted above, all per share amounts have been computed based on weighted-average common and common equivalent shares after giving effect to the three-for-two common stock split declared on October 22, 2004 as if it had occurred on January 1, 2003. Net income for the nine month period ended September 30, 2004 totaled $2,774,080 ($2.42 basic and $2.32 diluted earnings per share) compared with a total of $1,747,141 ($1.55 basic and $1.47 diluted earnings per share) for the same period in the prior year. This increase of $1,026,939 or 58.8% was caused by an increase in net interest income, which was partially offset by an increase in provision for loan losses, a decrease in noninterest income, an increase in income tax expense, and an increase in noninterest expenses. For the nine month period ended September 30, 2004, interest income increased by $3,259,217 or 27.4% to $15,158,283. The increase was due to higher average interest earning asset balances, including investments and loans, which were partially offset by lower average rates on loans. Interest expense also increased to $5,252,532 in the nine month period ending September 30, 2004 as compared to $4,171,862 in the same period in the prior year an increase of $1,080,670 or 25.9%. The increase was the result of higher average balances, which more than offset lower average rates paid on advances and deposits. The changes in average interest rates reflected several factors including an increase in short term interest rates, changes in the composition of borrowings, continued growth in certain deposit products, and continued growth in certain loan products.

Provision for loan losses increased from prior year levels to $316,970 from $145,340 for the nine month period ending

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September 30, 2004 and 2003, respectively. The increase was caused by the growth of the Bank’s loan portfolio, and by the establishment of a specific allowance in the current quarter of $113,000 to provide for estimated losses on certain consumer loans. Management will continue to periodically review its allowance for loan losses and the related provision and adjust as deemed necessary. This review will include a review of economic conditions nationally and locally, as well as a review of the performance of significant major loans and the overall portfolio.

Noninterest income decreased to $1,160,129 for the nine month period ending September 30, 2004, a decrease of $168,118 or 12.7% over the prior year total of $1,328,247. Loan appraisal, credit, and miscellaneous charges increased by $8,893 to $215,023. The Bank also recorded $221,544 in income from Bank Owned Life Insurance (“BOLI”), compared to $153,738 in 2003, an increase of $67,806 or 44.1%. This increase was the result of a BOLI purchase at the end of the first quarter of 2003. Service charges increased by $361,203 or 78.6% from the prior year amount. The increase was due to strong increases in deposits, increases in the sale of nondeposit products, and charges recorded in the prior year against originated mortgage servicing rights. These increases were offset by a decrease in gains from selling loans, which decreased to $21,404 from $499,726, a decrease of $478,322 or 95.7%. This change reflects the Bank’s preference to keep a higher proportion of loans in its portfolio. Finally the Company recorded a loss on the sale of certain investment securities available for sale, which reflected recognition of a loss in value of certain equity securities and some losses related to selling mutual funds.

Noninterest expense for the nine month period increased by $756,591 or 12.1% to $7,020,796 from $6,264,205 for the same Whyperiod of the prior year. Salary and employee benefits increased by 11.1% to $3,921,756 from $3,530,637 for the same period of the prior year. The increase was attributable to an increase in employees and to increases in average salary costs per employee. Benefits costs also increased due to increases in insurance costs as well as the addition of certain benefits. Occupancy expense increased to $575,624 from $547,306 an increase of 5.2% due to additional locations and increased costs at certain locations. Advertising increased to $368,314 from $224,066, an increase of $144,248 or 64.4%. Advertising increased due to an increase in certain sales efforts. Data processing expense increased to $411,568 from a prior year total of $297,075 an increase of $114,493 or 38.5%. This increase was due to certain nonrecurring expenses. Depreciation of furniture fixtures an