The Company maintains funds in restricted accounts at its insurance subsidiaries in order to comply with certain requirements imposed on insurance companies by the State of Georgia and to meet the reserve requirements of its reinsurance agreements.  Restricted cash also includes escrow deposits held by the Company on behalf of certain mortgage real estate customers.  At March 31, 2013, restricted cash Increased  $.2 million (5%) compared to December 31, 2012.

Other assets declined $1.6 million (9%) at March 31, 2013 compared to December 31, 2012 mainly due to the receipt of payment on accounts receivable outstanding as of the previous year end which were associated with the Company's insurance reinsurance business.

The aggregate amount of senior and subordinated debt outstanding at March 31, 2013 was $326.7 million compared to $318.8 million at December 31, 2012, representing a 2% increase.  

Accrued expenses and other liabilities declined $7.1 million (31%) at March 31, 2013 compared to December 31, 2012 mainly due to disbursement of the 2012 incentive bonus in February 2013.  Also contributing to the decrease was lower accrued salary expenses at March 31, 2013.

Results of Operations:

The Company generated $45.3 million in revenues during the three-month period ended March 31, 2013 compared to $41.9 million during the three-month period ended March 31, 2012. The higher revenue during the current year period was mainly due to higher interest and finance charge income earned on our loan and investment portfolios.  Although revenue was higher, net income declined $.2 million (2%) during the comparable periods  due to increases in expenses and higher income taxes.

2

Net Interest Income

Offsetting a portion of the increase in our net interest income was an increase in interest expense.  During the three-month period ended March 31, 2013, interest expense increased $.1 million or 2% compared to the same period a year ago mainly due to a $27.8 million increase in average borrowings outstanding.  Lower average interest rates on the Company’s debt offset a portion of the increase in interest expense.  The Company's average borrowing rate decreased to 3.50% during the three-month period just ended compared to 3.76% during the same period a year ago.  

Management projects that, based on historical results, average net receivables will continue to grow through the remainder of the year, and earnings are expected to increase accordingly.  However, a decrease in net receivables, or an increase in interest rates on outstanding borrowings could negatively impact our net interest margin.  

Insurance Income

Primarily as a result of the aforementioned increase in average net loans outstanding, the Company experienced a $.3 million (4%) increase in net insurance income during the three- month periods ended March 31, 2013 compared to the same period a year ago.    As average net receivables increase, the Company typically sees an increase in levels of insurance in-force as more loan customers opt for insurance coverage with their loan.  The increase in net insurance income during the three-month period just ended was partially offset by higher claims expense during the same period.

Provision for Loan Losses

The Company’s provision for loan losses is a charge against earnings to maintain the allowance for loan losses at a level that Management estimates is adequate to cover probable losses inherent as of the date of the statement of financial position.  

Our provision for loan losses increased $1.4 million (34%) during the three-month period just ended as compared to the same period a year ago.  The Company experienced a higher level of net charge offs during the period just ended.  Net charge offs were $5.5 million and $4.1 million during the three-month periods ended March 31, 2013 and 2012.  

Management continues to monitor unemployment rates, which have decreased slightly in recent periods, but remain higher than historical averages in the states in which we operate.  Volatility in gasoline prices is also being monitored.  These factors tend to adversely impact our customers which, in turn, could have an adverse impact on our allowance for loan losses. Based on present and expected overall economic conditions, however, Management believes the allowance for loan losses is adequate to absorb losses inherent in the loan portfolio as of March 31, 2013.  However, continued high levels of unemployment and/or volatile market conditions could cause actual losses to vary materially from our estimated amounts.  Management may determine it is appropriate to increase the allowance for loan losses in future periods, or actual losses could exceed allowances in any period, either of which events could have a material negative impact on our results of operations in the future.

3

Other Operating Expenses

During the three-month period ended March 31, 2013, the Company's other operating expenses increased $1.5 million (7%) compared to the same period a year ago.  Increases in personnel expense was the primary cause of the overall increase.  

Annual merit salary increases, increases in the Company's incentive bonus accrual and higher payroll taxes led to a $1.1 million (8%) increase in personnel cost during the three-month period ended March 31, 2013 compared to the same period in 2012.  Higher medical claims associated with the Company’s self-insured employee medical plan during the three-month period just ended also contributed to the overall increase in personnel expense for that period.

Higher maintenance costs on equipment, utilities expense, depreciation expense and increased rent expense caused occupancy expense to increase $.1 million (3%) duirng the three-month period just ended compared to the same period in 2012.

During the three-month periods ended March 31, 2013, miscellaneous other operating expenses increased $.3 million (6%) compared to the same period in 2012.  The increase was mainly the result of higher advertising expenses, increased computer expenses and increased taxes and licensing fees.  The increase was partially offset by decreases in legal and audit expenses and other miscellaneous expenses.

Income Taxes

The Company has elected to be, and is, treated as an S corporation for income tax reporting purposes.  Taxable income or loss of an S corporation is passed through to, and included in the individual tax returns of, the shareholders of the Company, rather then being taxed at the corporate level.  Notwithstanding this election, however, income taxes continue to be reported for, and paid by, the Company's insurance subsidiaries as they are not allowed to be treated as S corporations, and for the Company’s state taxes in Louisiana, which does not recognize S corporation status.  Deferred income tax assets and liabilities are recognized and provisions for current and deferred income taxes continue to be recorded by the Company’s subsidiaries.  The Company uses the liability method of accounting for deferred income taxes and provides deferred income taxes for all significant income tax temporary differences.  

Effective income tax rates were 10% and 7% during the three-month periods ended March 31, 2013 and 2012, respectively.  The Company’s effective tax rates during the reporting periods were lower than statutory rates due to income at the S corporation level being passed to the shareholders of the Company for tax reporting purposes, whereas income earned at the insurance subsidiary level was taxed at the corporate level.  The tax rates of the Company’s insurance subsidiaries are below statutory rates due to investments in tax exempt bonds held by the Company’s property insurance subsidiary.  Certain benefits provided by law to small life insurance companies also contributed to the reduced effective tax rates during the three-month period ending March 31, 2012.  One of the conditons for the Company's life insurance subsidiary to be eligible for certain tax benefits was consolidated Company assets not in excess of $500.0 million.  Our consolidated assets exceeded this threshold during the latter part of 2012, therefore the benefit is no longer available to our life insurance subsidiary going forward.

Quantitative and Qualitative Disclosures About Market Risk:

Interest rates continued to be near historical low levels during the reporting period.  We currently expect only minimal fluctuations in market interest rates during the remainder of the year, thereby minimizing the expected impact on our net interest margin; however, no assurances can be given in this regard.  Please refer to the market risk analysis discussion contained in our 2012 Annual Report on Form 10-K as of and for the year ended December 31, 2012 for a more detailed analysis of our market risk exposure.  There were no material changes in our risk exposures in the three months ended March 31, 2013 as compared to those at December 31, 2012.

4

Liquidity and Capital Resources:

As of March 31, 2013 and December 31, 2012, the Company had $54.5 million and $28.2 million, respectively, invested in cash and cash equivalents, the majority of which was held by the parent company.  

The Company’s investments in marketable securities can be readily converted into cash, if necessary.  State insurance regulations limit the use an insurance company can make of its assets.  Dividend payments to a parent company by its wholly-owned insurance subsidiaries are subject to annual limitations and are restricted to the greater of 10% of policyholders’ surplus or statutory earnings before recognizing realized investment gains of the individual insurance subsidiaries.  At December 31, 2012, Frandisco Property and Casualty Insurance Company (“Frandisco P&C”) and Frandisco Life Insurance Company (“Frandisco Life”), the Company’s wholly-owned insurance subsidiaries, had policyholders’ surpluses of $51.2 million and $51.4 million, respectively.  The maximum aggregate amount of dividends these subsidiaries can pay to the Company in 2013, without prior approval of the Georgia Insurance Commissioner, is approximately $10.3 million.

The majority of the Company’s liquidity requirements are financed through the collection of receivables and through the sale of short- and long-term debt securities.  The Company’s continued liquidity is therefore dependent on the collection of its receivables and the sale of debt securities that meet the investment requirements of the public.  In addition to its receivables and securities sales, the Company has an external source of funds available under a credit facility with Wells Fargo Preferred Capital, Inc. (the “credit agreement”).  The credit agreement provides for borrowings of up to $100.0 million, subject to certain limitations, and all borrowings are secured by the finance receivables of the Company.  Available borrowings under the credit agreement were $100.0 million at March 31, 2013 and December 31, 2012, at an interest rate of 3.75%.  The credit agreement has a commitment maturity date of September 11, 2014.  The credit agreement contains covenants customary for financing transactions of this type.  At March 31, 2013, the Company was in compliance with all covenants.  Management believes this credit facility, when considered with the Company’s other expected sources of funds, should provide sufficient liquidity for the continued growth of the Company for the foreseeable future.

Critical Accounting Policies:

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the financial services industry. The Company’s critical accounting and reporting policies include the allowance for loan losses, revenue recognition and insurance claims reserves.  During the three months ended March 31, 2013, there were no material changes to the critical accounting policies or related estimates previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

Allowance for Loan Losses

Provisions for loan losses are charged to operations in amounts sufficient to maintain the allowance for loan losses at a level considered adequate to cover probable credit losses inherent in our loan portfolio.  

The allowance for loan losses is established based on the determination of the amount of probable losses inherent in the loan portfolio as of the reporting date.  We review, among other things, historical charge off experience factors, delinquency reports, historical collection rates, economic trends such as unemployment rates, gasoline prices and bankruptcy filings and other information in order to make what we believe are the necessary judgments as to probable losses.  Assumptions regarding probable losses are reviewed periodically and may be impacted by our actual loss experience and changes in any of the factors discussed above.

Revenue Recognition

Accounting principles generally accepted in the United States require that an interest yield method be used to calculate the income recognized on accounts which have precomputed

5

charges.  An interest yield method is used by the Company on each individual account with precomputed charges to calculate income for those active accounts; however, state regulations often allow interest refunds to be made according to the Rule of 78’s method for payoffs and renewals.  Since the majority of the Company's accounts with precomputed charges are paid off or renewed prior to maturity, the result is that most of those accounts effectively yield on a Rule of 78's basis.

Precomputed finance charges are included in the gross amount of certain direct cash loans, sales finance contracts and certain real estate loans.  These precomputed charges are deferred and recognized as income on an accrual basis using the effective interest method.  Some other cash loans and real estate loans, which do not have precomputed charges, have income recognized on a simple interest accrual basis.  Income is not accrued on any loan that is more than 60 days past due.

Loan fees and origination costs are deferred and recognized as adjustments to the loan yield over the contractual life of the related loan.  

The property and casualty credit insurance policies written by the Company, as agent for a non-affiliated insurance company, are reinsured by the Company’s property and casualty insurance subsidiary.  The premiums on these policies are deferred and earned over the period of insurance coverage using the pro-rata method or the effective yield method, depending on whether the amount of insurance coverage generally remains level or declines.

The credit life and accident and health insurance policies written by the Company, as agent for a non-affiliated insurance company, are reinsured by the Company’s life insurance subsidiary.  The premiums are deferred and earned using the pro-rata method for level-term life insurance policies and the effective yield method for decreasing-term life policies.  Premiums on accident and health insurance policies are earned based on an average of the pro-rata method and the effective yield method.

Insurance Claims Reserves

Included in unearned insurance premiums and commissions on the Unaudited Condensed Consolidated Statements of Financial Position are reserves for incurred but unpaid credit insurance claims for policies written by the Company and reinsured by the Company’s wholly-owned insurance subsidiaries.  These reserves are established based on generally accepted actuarial methods.  In the event that the Company’s actual reported losses for any given period are materially in excess of the previously estimated amounts, such losses could have a material adverse effect on the Company’s results of operations.

Different assumptions in the application of any of these policies could result in material changes in the Company’s consolidated financial position or consolidated results of operations.

Recent Accounting Pronouncements:

See “Recent Accounting Pronouncements” in Note 1 to the accompanying “Notes to Unaudited Condensed Consolidated Financial Statements” for a discussion of accounting standards and the expected impact of accounting standards recently issued but not yet required to be adopted.  For pronouncements already adopted, any material impacts on the Company’s consolidated financial statements are discussed in the applicable section(s) of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

6

10

-NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of 1^st Franklin Financial Corporation and subsidiaries (the "Company") should be read in conjunction with the audited consolidated financial statements of the Company and notes thereto as of December 31, 2012 and for the year then ended included in the Company's 2012 Annual Report filed with the Securities and Exchange Commission.

In the opinion of Management of the Company, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the Company's consolidated financial position as of March 31, 2013 and December 31, 2012, and its consolidated results of operations, comprehensive income and consolidated cash flows for the three month periods ended March 31, 2013 and 2012. While certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission, the Company believes that the disclosures herein are adequate to make the information presented not misleading.

The Company’s financial condition and results of operations as of and for the three months ended March 31, 2013 are not necessarily indicative of the results to be expected for the full fiscal year or any other future period.  The preparation of financial statements in accordance with GAAP requires Management to make estimates and assumptions that affect the reported amount of assets and liabilities at and as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from those estimates.

The computation of earnings per share is self-evident from the accompanying Unaudited Condensed Consolidated Statements of Income and Retained Earnings.  The Company has no dilutive securities outstanding.

Recent Accounting Pronouncements:

In February 2013, the FASB issued ASU 2013-02, "Reporting Out of Accumulated Other Comprehensive Income".  The guidance adds new disclosure requirements for items reclassified out of accumulated other comprehensive income.  This update requires that companies present either in a single note, or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items affected by the reclassification.  If a component is not required to be reclassified to net income in its entirety, companies would instead cross reference to the related footnote for additional information.  This update was effective for the Company beginning in the first quarter of 2013 and its adoption did not have a material impact on the consolidated financial statements.

Note 2 – Allowance for Loan Losses

The allowance for loan losses is based on Management's evaluation of the inherent risks and changes in the composition of the Company's loan portfolio.  Management’s approach to estimating and evaluating the allowance for loan losses is on a total portfolio level based on historical loss trends, bankruptcy trends, the level of receivables at the balance sheet date, payment patterns and economic conditions primarily including, but not limited to, unemployment levels and gasoline prices.  Historical loss trends are tracked on an on going basis.  The trend analysis includes statistical analysis of the correlation between loan date and charge off date, charge off statistics by the total loan portfolio, and charge off statistics by branch, division and state.  Delinquency and bankruptcy filing trends are also tracked.  If trends indicate an adjustment to the allowance for loan losses is warranted, Management will make what it considers to be

11

appropriate adjustments.  The level of receivables at the balance sheet date is reviewed and adjustments to the allowance for loan losses are made if Management determines increases or decreases in the level of receivables warrants an adjustment.  The Company uses monthly unemployment statistics, and various other monthly or periodic economic statistics, published by departments of the U.S. government and other economic statistics providers to determine the economic component of the allowance for loan losses.  Such allowance is, in the opinion of Management, sufficiently adequate for probable losses in the current loan portfolio.  As the estimates used in determining the loan loss reserve are influenced by outside factors, such as consumer payment patterns and general economic conditions, there is uncertainty inherent in these estimates.  Actual results could vary based on future changes in significant assumptions.

Management does not disaggregate the Company’s loan portfolio by loan class when evaluating loan performance.  The total portfolio is evaluated for credit losses based on contractual delinquency and other economic conditions. The Company classifies delinquent accounts at the end of each month according to the number of installments past due at that time, based on the then-existing terms of the contract.  Accounts are classified in delinquency categories based on the number of days past due.  When three installments are past due, we classify the account as being 60-89 days past due; when four or more installments are past due, we classify the account as being 90 days or more past due.  When a loan becomes five installments past due, it is charged off unless Management directs that it be retained as an active loan. In making this charge off evaluation, Management considers factors such as pending insurance, bankruptcy status and other indicators of collectability. In addition, no installment is counted as being past due if at least 80% of the contractual payment has been paid. In connection with any bankruptcy court-initiated repayment plan and as allowed by state regulatory authorities, the Company effectively resets the delinquency rating of each account to coincide with the court initiated repayment plan. The amount charged off is the unpaid balance less the unearned finance charges and the unearned insurance premiums, if applicable.

When a loan becomes 60 days or more past due based on its original terms, it is placed in nonaccrual status.  At such time, the accrual of any additional finance charges is discontinued.  Finance charges are then only recognized to the extent there is a loan payment received or when the account qualifies for return to accrual status.  Nonaccrual loans return to accrual status when the loan becomes less than 60 days past due.  There were no loans past due 60 days or more and still accruing interest at March 31, 2013 or December 31, 2012.  The Company’s principal balances on non-accrual loans by loan class as of March 31, 2013 and December 31, 2012 are as follows:

An age analysis of principal balances on past due loans, segregated by loan class, as of March 31, 2013 and December 31, 2012 follows:

12

In addition to the delinquency rating analysis, the ratio of bankrupt accounts to the total loan portfolio is also used as a credit quality indicator.  The ratio of bankrupt accounts outstanding to total principal loan balances outstanding at March 31, 2013 and December 31, 2012 was 2.93% and 2.64%, respectively.

Nearly our entire loan portfolio consists of small homogeneous consumer loans (of the product types set forth in the table below).  

Sales finance contracts are similar to consumer loans in nature of loan product, terms, customer base to whom these products are marketed, factors contributing to risk of loss and historical payment performance, and together with consumer loans, represented approximately 95% of the Company’s loan portfolio at March 31, 2013 and 2012.  As a result of these similarities, which have resulted in similar historical performance, consumer loans and sales finance contracts represent substantially all loan losses.  Real estate loans and related losses have historically been insignificant, and, as a result, we do not stratify the loan portfolio for purposes of determining and evaluating our loan loss allowance.  Due to the composition of the loan portfolio, the Company determines and monitors the allowance for loan losses on a collectively evaluated, single portfolio segment basis.  Therefore, a roll forward of the allowance for loan loss activity at the portfolio segment level is the same as at the total portfolio level.  We have not acquired any impaired loans with deteriorating quality during any period reported.  The following table provides additional information on our allowance for loan losses based on a collective evaluation:

13

Troubled Debt Restructings ("TDR's") represent loans on which the original terms of the loans have been modified as a result of the following conditions: (i) the restructuring constitutes a concession and (ii) the borrower is experiencing financial difficulties. Loan modifications by the Company involve payment alterations, interest rate concessions and/ or reductions in the amount owed by the borrower.  The following table presents a summary of loans that were restructured during the three months ended March 31, 2013.

The following table presents a summary of loans that were restructured during the three months ended March 31, 2012.

TDRs that occurred during the previous twelve months and subsequently defaulted during the three months ended March 31, 2013 are listed below.  

TDRs that occurred during the previous twelve months and subsequently defaulted during the three months ended March 31, 2012 are listed below.

14

The level of TDRs, including those which have experienced a subsequent default, is considered in the determination of an appropriate level of allowance of loan losses.

Note 3 – Investment Securities

Debt securities available-for-sale are carried at estimated fair value. Debt securities designated as "Held to Maturity" are carried at amortized cost based on Management's intent and ability to hold such securities to maturity.  The amortized cost and estimated fair values of these debt securities were as follows: