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U.S. Securities and Exchange Commission

Washington, D. C. 20549

FORM 10-K

OR

For the transition period from              to             

SOUTHERN FINANCIAL BANCORP, INC.

(Exact name of registrant as specified in its charter)

37 East Main Street, Warrenton, Virginia 20186

(Address of principal executive office) (Zip Code)

(540) 349-3900

(Registrant’s telephone number, including area code)

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 $0.01 per share

(Title of Class)

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

The aggregate market value of the Common Stock held by non-affiliates of the registrant computed by reference to the last reported bid price of such stock as of March 1, 2004 was $298,523,379 (6,428,152 shares @ $46.44 per share). For purposes of this computation, it is assumed that directors, executive officers and persons beneficially owning more than 5% of the Common Stock of the registrant are affiliates. As of March 1, 2004, there were 7,437,380 shares of the registrant’s Common Stock outstanding.

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

The aggregate market value of the Common Stock held by non-affiliates of the registrant computed by reference to the last reported bid price of such stock as of June 30, 2003, was $120,557,418 (4,390,292 shares @ $27.46 per share). For purposes of this computation, it is assumed that directors, executive officers and persons beneficially owning more than 5% of the Common Stock of the registrant are affiliates. As of June 30, 2003, there were 5,491,433 shares of the registrant’s Common Stock outstanding.

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INDEX

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Part I.

Item 1. Business

Overview

We were formed in 1995 as a bank holding company for Southern Financial Bank (the Bank), which was chartered in 1986. Our financial performance has been characterized by steady asset growth, consistent core earnings and sound asset quality. We have grown through a combination of internal growth, the opening of de novo branches and the acquisition of community banks and branches in our market. We have established 16 branches and acquired one branch in the last 17 years. Three acquisitions, The Horizon Bank of Virginia (Horizon) in October 1999, First Savings Bank of Virginia in September 2000, and Metro-County Bank of Virginia in August 2002 added $303.8 million in assets, provided us with eleven additional branch locations and enhanced our core deposit base. We currently operate 28 full-service banking locations, 19 of which are located in the northern Virginia cities of Warrenton, Herndon, Middleburg, Winchester, Leesburg, Fairfax, Sterling, Woodbridge, Manassas and Fredericksburg. In August 2001 we opened our twentieth branch in Georgetown in the District of Columbia and, in January 2002 we opened a branch in Charlottesville, Virginia. The five branches acquired from Metro-County Bank are located in the Richmond area, and in February 2003 we opened a new branch in Charlottesville, Virginia. In November 2003 we opened a new branch in Richmond, Virginia.

We have expanded from our roots in Fairfax County, where we maintain eight branches and 50% of our transactional deposits, to encompass a market area extending from Winchester in northwest Virginia to Richmond, approximately 150 miles to the southeast. This area has been characterized by high growth and general affluence. As its economy has diversified away from a concentration in government and government-related employment, northern Virginia has developed into a major center for technology and telecommunications activities and has a high concentration of small to medium-sized businesses representing a diverse array of industries. In the process, Reston, Herndon, Tysons Corner and Fairfax have become important stand alone employment centers similar to Stamford, Connecticut and White Plains, New York, which have flourished outside of New York City. As a result, the “bedroom communities” supporting business clusters have pushed west to Loudoun and Fauquier Counties and south and west to Stafford, Spotsylvania and Prince William Counties. We also believe that the high growth and general affluence in certain of the areas adjoining our current market area provide the same attractive expansion opportunities. In addition to the District of Columbia, we believe that Montgomery County, Maryland and the Richmond, Virginia area are also attractive targets. Upon the opening of our branch in Charlottesville, our market area expands to include Albemarle, Greene and Fluvanna Counties, all of which have experienced rapid population growth in the last decade.

On August 14, 2002, Southern Financial acquired all the outstanding common stock of Metro-County Bank of Virginia for 354,711 shares of Southern Financial common stock and cash in the amount of $6,841,584. The merger was accounted for in accordance with Statement of Financial Standards No. 141 (SFAS No. 141), Business Combinations, and the results of operations of Metro-County Bank have been included in our consolidated financial statements from August 15, 2002. The excess of the purchase price over the fair value of the net identifiable assets acquired has been recorded as goodwill in the amount of $9,439,408 and core deposit intangible assets in the amount of $2,400,000. The core deposit intangible assets are being amortized over ten years. The factors considered in the decision to acquire Metro-County Bank included the opportunity for future growth and an expanded geographic presence, as the acquisition of Metro-County’s locations in the greater Richmond area is a natural extension of our geographic area and fits well into our expansion plans.

On September 1, 2000, we acquired all the outstanding common stock of First Savings Bank of Virginia for 409,906 shares of our common stock. The acquisition has been accounted for by the purchase method, and accordingly, the results of operations of First Savings Bank have been included in our consolidated financial statements from September 1, 2000. Goodwill of $1,646,651 was recorded, which was being amortized through December 31, 2001 on a straight-line basis over 15 years along with a core deposit premium of $1,566,163, which is being amortized over 10 years. In connection with our adoption of SFAS No. 142, Goodwill and Other Intangible Assets, beginning January 1, 2002, this goodwill will no longer be amortized.

On December 28, 1999, we formed Southern Financial Capital Trust I, a wholly-owned subsidiary, for the purpose of issuing redeemable capital securities. On May 24, 2000, a $5 million offering of redeemable capital securities was completed, and on September 7, 2000, $8 million of trust preferred securities were issued through a pooled underwriting totaling approximately $300 million. On April 10, 2003, $10 million of trust preferred securities were issued through a pooled underwriting.

On October 1,1999, we completed our merger with Horizon. The merger qualified as a tax-free exchange and was accounted for as a pooling of interests. We issued .63 shares of our common stock for each share of Horizon stock outstanding. A total of 1,045,523 shares (after adjustment for fractional shares) of our common stock were issued as a result of the merger. Horizon had no stock options outstanding prior to the merger. Southern Financial and Horizon incurred $3,973,530 of merger-related costs that were charged to operations during the year ended December 31, 1999.

Our principal business is the acquisition of deposits from the general public through our home and branch offices and use of these deposits to fund our loan and investment portfolios. We seek to be a full service community bank that provides a wide variety of financial services to our middle market corporate clients as well as to our retail clients. We are an active commercial lender that often lends in conjunction with the Small Business Administration 7(a) and 504 loan programs. In addition, we are an active residential construction lender and offer our retail clients permanent residential mortgage loan alternatives. We also invest funds in mortgage-backed securities, securities issued by agencies of the Federal Government, obligations of counties and municipalities and corporate obligations.

The principal sources of funds for our lending and investment activities are deposits, amortization and repayment of loans, proceeds from the sales of loans, prepayments from mortgage-backed securities, repayments of maturing investment securities, Federal Home Loan Bank advances and other borrowed money.

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Principal sources of revenue are interest and fees on loans and investment securities, as well as fee income derived from the maintenance of deposit accounts. Our principal expenses include interest paid on deposits and advances from the Federal Home Loan Bank and other borrowings, and operating expenses.

Lending Activities

Our primary strategic objective is to serve the small to medium-sized business market with an array of unique and useful services, including a full array of commercial mortgage and nonmortgage loans. These loans include commercial real estate loans, construction to permanent loans, development and builder loans, accounts receivable financing, lines of credit, equipment and vehicle loans, leasing options, commercial overdraft protection and corporate credit cards. We strive to do business in the areas served by our branches, and all of our marketing and the vast majority of our loan customers are located within our existing market areas. The only significant exceptions to this local lending philosophy are loans made with an undertaking from the Small Business Administration that may from time to time come to us because of our reputation and expertise as an SBA lender. Prior to making a loan, we obtain detailed loan applications to determine the borrower’s ability to repay, and the more significant items on these applications are verified through the use of credit reports, financial statements and confirmations. The following is a discussion of each of our major types of lending:

Commercial Real Estate Lending

Permanent. Commercial real estate lending includes loans for permanent financing and construction. Commercial real estate lending typically involves higher loan principal amounts and the repayment of loans is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. As a general practice, we require our commercial real estate loans to be secured by well-managed income producing property with adequate margins and to be guaranteed by responsible parties. We look for opportunities where cash flow from the collateral provides adequate debt service coverage and the guarantor’s net worth is centered on assets other than the project we finance. It has been our experience that borrowers whose assets consist entirely of real estate, especially development projects, are particularly sensitive to real estate market cycles. In the event of a slowdown in the real estate market, real estate projects generally come under pressure at the same time and liquidity of the borrower may be strained. As of December 31, 2003, our commercial real estate loans for permanent financing totaled $286.0 million.

Our underwriting guidelines for commercial real estate loans reflect all relevant credit factors, including, among other things, the income generated from the underlying property to adequately service the debt, the availability of secondary sources of repayment and the overall creditworthiness of the borrower. In addition, we look to the value of the collateral, while maintaining the level of equity invested by the borrower.

All valuations on property that will secure loans are performed by independent outside appraisers who are reviewed by our Executive Vice President of Risk Management and reported annually to our Credit Committee. We retain a valid lien on real estate and obtain a title insurance policy that insures the property is free of encumbrances.

Construction. We recognize that commercial, multifamily and other nonresidential properties can involve market risk due to the length of time it may take to bring a finished real estate product to market. As a result, we will only make these types of loans when pre-leasing or pre-sales and or other credit factors suggest that the borrower can carry the debt if the anticipated market and property cash flow projections change during the construction phase. At December 31, 2003, we had $60.7 million commercial construction loans.

Income producing property loans are supported by evidence of the borrower’s capacity to service the debt. The principals or general partners guarantee all of our commercial construction loans. Any interest reserves established on conventional construction loans are not funded with the proceeds of the loan.

Construction loan borrowers are generally pre-qualified for the permanent loan by us. We obtain a copy of the contract with the general contractor who must be acceptable to us. All plans, specifications and surveys must include proposed improvements. We review feasibility studies and sensitivity and risk analysis showing sensitivity of the project to variables such as interest rates, vacancy rates, lease rates and operating expenses for income producing properties and copies of any previous environment site assessments if applicable.

Commercial Business Lending

These loans consist of lines of credit, revolving credit facilities, demand loans, term loans, equipment loans, SBA loans, stand-by letters of credit and unsecured loans. Commercial business loans are generally secured by accounts receivable, equipment and other collateral, such as readily marketable stocks and bonds with adequate margins, cash value in life insurance policies and savings and time deposits at the Bank. At December 31, 2003, our commercial business loans totaled $163.0 million, including $20.7 million of debt obligations.

In general, commercial business loans involve more credit risk than residential mortgage loans and real estate-backed commercial loans and, therefore, usually yield a higher return to us. The increased risk for commercial business loans is due to the type of collateral securing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced principally from the operations of the business, and those operations may not be successful. Historical trends have shown these types of loans to have higher delinquencies than mortgage loans. Because of this, we often utilize the SBA 7(a) program to reduce the inherent risk associated with commercial business lending.

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Another way that we reduce risk in the commercial loan portfolio is by taking accounts receivable as collateral. Our accounts receivable financing facilities, which provide a relatively high yield with considerable collateral control, are lines of credit under which a company can borrow up to the amount of a borrowing base which covers all of the company’s receivables. From our customer’s point of view, accounts receivable financing is an efficient way to finance expanding operations because borrowing capacity expands as sales increase. Customers can borrow from 75% to 90% of qualified receivables placed in our system less accounts over 60 days past due. In most cases, the borrower’s customers pay us directly. For borrowers with a good track record for earnings and quality receivables, we will consider pricing based on the prime rate for transactions in which we lend up to a percentage of qualified outstanding receivables based on reported agings of the receivables portfolio.

We also actively pursue for our customers, equipment lease financing opportunities other than cars, trucks and other on-road rolling stock. We provide financing and use a third party to service the leases. Payback is derived from the cash flow of the borrower, so credit quality may not be any lower than it would be in the case of an unsecured loan for a similar amount and term.

SBA Lending

We have developed an expertise in the federally guaranteed SBA program. The SBA program is an economic development program that finances the expansion of small businesses. We are a Preferred Lender in the Richmond District and a Certified Lender in the Washington D. C. District of the SBA. As an SBA Preferred and Certified Lender, our preapproved status allows us to quickly respond to customers’ needs. Under the SBA program, we originate and fund SBA 7(a) loans that qualify for guarantees up to 85% of principal and accrued interest. We also originate 504 chapter loans in which we generally provide 50% of the financing in the form of a first lien. At December 31, 2003, our total SBA loans were $56.4 million, which consisted of $35.2 million of 7(a) program loans and $21.2 million of 504 chapter loans.

We provide SBA loans to potential borrowers who are proposing a business venture, often with existing cash flow and a reasonable chance of success. We do not treat the SBA guarantee as a substitute for a borrower meeting our credit standards, and except for minimum capital levels or maximum loan terms, the borrower must meet our other credit standards as applicable to loans outside the SBA process.

Residential Mortgage Lending

Permanent. Residential mortgage loans are secured by single-family homes. We make fixed and adjustable rate first mortgage loans on residential properties with terms up to 30 years. We offer second mortgages in conjunction with our own first mortgages or those of other lenders. In the case of conventional loans, we typically lend up to 80% of the appraised value of single-family residences and require private mortgage insurance for loans exceeding this amount. At December 31, 2003, we had $50.3 million of permanent residential mortgage loans.

We retain a valid lien on real estate and obtain a title insurance policy that insures that the property is free of encumbrances. We also require hazard insurance and flood insurance for all loans secured by real property if the property is in a flood plain as designated by the Department of Housing and Urban Development. We also require most borrowers to advance funds on a monthly basis from which we make disbursements for items such as real estate taxes, private mortgage insurance and hazard insurance.

Construction. We typically make one to four family residential construction loans to builders/developers in our market areas. Construction loans generally have interest rates of prime plus one to two percent and fees of one to three points, loan-to-value ratios of 80% or less based on current appraisals and terms of generally nine months or less. In substantially all cases, when we make a residential construction loan to a builder, the residence is pre-sold All plans, specifications and surveys must include proposed improvements. Borrowers must evidence the capacity to service the debt. At December 31, 2003, we had $40.3 million of residential construction loans.

Consumer Lending

We offer various types of secured and unsecured consumer loans. We make consumer loans primarily for personal, family or household purposes as a convenience to our customer base since these loans are not the focus of our lending activities. As a general guideline, a consumer’s total debt service should not exceed 40% of his gross income or 45% of net income. For purposes of this calculation, debt includes house payment or rent, fixed installment payments, the estimated payment for the loan being requested and the minimum required payment on any revolving debt. At December 31, 2003, we had $7.7 million of consumer loans.

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Loan Portfolio Composition

The following table summarizes the composition of our loan portfolio as of December 31 for the years indicated:

The following table sets forth the contractual maturity ranges of the commercial and industrial loans and construction loans and the amount of those loans with predetermined and floating interest rates in each maturity range as of December 31, 2003:

Credit Approval and Collection Policies

Because long-term credit performance is so closely associated with a bank’s underwriting policy, we have instituted what management believes is a stringent loan underwriting policy. Our underwriting guidelines are tailored for particular credit types, including lines of credit, revolving credit facilities, demand loans, term loans, equipment loans, real estate loans, SBA loans, stand-by letters of credit and unsecured loans. We will make extensions of credit based on, among other factors, the potential borrower’s creditworthiness, likelihood of repayment and proximity to market areas served.

We have a standing Credit Committee comprised of certain of our officers, each of whom has a defined lending authority as an individual and in combination with other officers. These individual lending authorities are determined by our Chief Executive Officer and certain directors and are based on the individual’s technical ability and experience. These authorities must be approved by our board of directors and the Credit Committee. Our Credit Committee is comprised of four levels of members: junior, regular, senior and executive, based on experience. Our executive members are our Chief Executive Officer, our President and two appointed Executive Vice Presidents. Under our loan approval process, the sponsoring loan officer’s approval is required on all credit submissions. This approval must be included in or added to the individual and joining authorities outlined below. The sponsoring loan

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officer is primarily responsible for the customer’s relationship with us, including, among other things, obtaining and maintaining adequate credit file information. We require each loan officer to maintain loan files in an order and detail that would enable a disinterested third party to review the file and determine the current status and quality of the credit.

In addition to approval of the sponsoring loan officer, we require approvals from one or more members of the Credit Committee on all loans. The approvals required differ based on the size of the borrowing relationship. At least one senior or one executive member must approve all loans in the amount of $100,000 or more. All three of the executive members of the Committee must approve all loans of $1 million or more. Regardless of the number of approvals needed, we encourage each member to treat his or her approval as if it were the only approval necessary to approve the loan. Our legal lending limit to one borrower is limited to 15% of our unimpaired capital and surplus. As of December 31, 2003, our lending limit was approximately $13.9 million, although we had no loans to one borrower that approached our legal lending limit at that date.

The following collection actions are the minimal procedures which management believes are necessary to properly monitor past due loans and leases. When a borrower fails to make a payment, we contact the borrower in person, in writing and by telephone. At a minimum, all borrowers are notified by mail when payments of principal and/or interest are five days past due and when payments are 10 days past due. In addition, consumer loan borrowers are assessed a late charge when payments are 10 days past due. Real estate and commercial loan borrowers are assessed a late charge when payments are 15 days past due. Customers are contacted by a loan officer before the loan becomes 60 days delinquent. After 90 days, if the loan has not been brought current or an acceptable arrangement is not worked out with the borrower, we will institute measures to remedy the default, including commencing foreclosure action with respect to mortgage loans and repossessions of collateral in the case of consumer loans.

If foreclosure is effected, the property is sold at a public auction in which we may participate as a bidder. If we are the successful bidder, we include the acquired real estate property in our real estate owned account until it is sold. These assets are carried at the lower of cost or fair value net of estimated selling costs. To the extent there is a decline in value, that amount is charged to operating expense.

Past Due Loans and Nonperforming Assets

Nonperforming assets were $5.8 million at December 31, 2003 compared with $2.3 million at December 31, 2002. Our ratio of nonperforming assets to total loans and other real estate owned was 0.94% at December 31, 2003 and 0.37% at December 31, 2002.

Nonperforming assets were $2.3 million at December 31, 2002 compared with $1.5 million at December 31, 2001. The ratio of nonperforming assets to total loans and other real estate owned was 0.37% at December 31, 2002 and 0.35% at December 31, 2001.

We generally place a loan on nonaccrual status when it becomes 90 days past due. Loans are also placed on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Cash payments received while a loan is categorized as nonaccrual are recorded as a reduction of principal as long as doubt exists as to future collections.

We maintain appraisals on loans secured by real estate, particularly those categorized as nonperforming loans and potential problem loans. In instances where appraisals reflect reduced collateral values, we make an evaluation of the borrower’s overall financial condition to determine the need, if any, for possible writedowns to their net realizable values. We record other real estate owned at the lower of our recorded investment in the loan or fair value less our estimated costs to sell.

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The following table sets forth information regarding past due loans and nonperforming assets as of the dates indicated: