Overview

Financial Federal Corporation is an independent financial services company operating in the United States through three wholly owned subsidiaries. We do not have any unconsolidated subsidiaries, partnerships or joint ventures. We also do not have any off-balance sheet assets or liabilities (other than commitments to extend credit), goodwill, other intangible assets or pension obligations, and we are not involved in income tax shelters. We have one fully consolidated special purpose entity we established for our on-balance-sheet asset securitization facility.

We have one line of business. We lend money under installment sale agreements, secured loans and leases (collectively referred to as "finance receivables") to small and medium sized businesses for their equipment financing needs. Finance receivable transactions generally range between $50,000 and $1.5 million, have terms between two and five years and require monthly payments. The average transaction size is approximately $250,000. We earn revenue solely from interest and other fees and amounts earned on our finance receivables. We need to borrow most of the money we lend. Therefore, liquidity (money currently available for us to borrow) is very important. We borrow from banks and insurance companies and we issue commercial paper to other investors. Approximately 75% of our finance receivables were funded with debt at January 31, 2009.

Our main areas of focus are (i) asset quality (ii) liquidity (iii) net interest spread (the difference between the rates we earn on our receivables and the rates we incur on our debt) and (iv) interest rate risk. Changes in the asset quality of our finance receivables can affect our profitability significantly. Finance income, provisions for credit losses and operating expenses can be affected by reclassifying receivables to or from impaired status, incurring write-downs and incurring costs associated with non-performing assets. Changes in market interest rates can also affect our profitability significantly because interest rates on our finance receivables were 91% fixed and 9% floating, and interest rates on our debt were 61% fixed and 39% floating at January 31, 2009. We use various strategies to manage our credit risk and interest rate risk. Each of these four areas is integral to our long-term profitability and we discuss them in detail in separate sections of this discussion.

Our key operating statistics are net charge-offs, loss ratio, non-performing assets, delinquencies, leverage, available liquidity, receivables growth, return on equity, net interest margin and net interest spread, and expense and efficiency ratios.

Significant events

The crisis in credit markets that began over one year ago worsened considerably during the first half of fiscal 2009 causing credit markets to nearly collapse. It is now even more difficult and expensive for finance companies to obtain or renew financing. Banks and other lenders, including all of our funding sources, are either reluctant or unable to provide, or are charging prohibitively high credit spreads, on new financing. Credit spread is the percentage amount lenders charge above a base market interest rate. Our cost of debt will increase considerably as we obtain or renew financing if credit spreads persist at these levels.

The Federal Reserve, United States Treasury Department and FDIC have taken unprecedented, drastic steps to address the crisis including lowering the target Federal Funds Rate ten times since September 2007 to between zero and 0.25%; the lowest level in history. This includes three decreases totaling 175 basis points during the first half of fiscal 2009. They injected over $1.0 trillion into the financial system through several programs to prevent it from failing and to encourage lending. We are not eligible to participate in these programs because we are not a bank holding company and our commercial paper is rated F2.

Our available liquidity has increased by $189.3 million during the crisis to $429.3 million at January 31, 2009 from $240.0 million at July 31, 2007. The increase resulted from significantly lower receivable originations, strong operating cash flows and the following transactions. We partially renewed our $425.0 million asset securitization facility for another year in April 2008. Two of the four banks in the facility increased their $225.0 million combined commitment by $100.0 million and we converted the $200.0 million borrowed from the other two banks into amortizing term debt. We renewed a $25.0 million bank credit facility in March 2008 and a $30.0 million bank credit facility in September 2008. We also converted $75.0 million of bank credit facilities into five-year fixed rate term loans with a 4.43% average rate and we extended the term of a $15.0 million bank credit facility with no change in credit spread in February 2008. Based on our amount of available liquidity, the maturity and expiration dates of our debt and credit facilities (including the expected repayment of our $132.7 million of convertible debentures in April 2009) and receivable originations continuing at recent

levels, we do not anticipate a need for any financing until the third quarter of fiscal 2010. We discuss our liquidity and debt in the Liquidity and Capital resources section.

In addition, our cost of debt has decreased during the crisis because (i) short-term market interest rates decreased significantly (ii) the relatively small amount of expiring credit facilities and maturing debt limited the impact of higher credit spreads and (iii) we have $480.0 million of low-cost committed bank credit facilities with no borrowing restrictions. Our cost of debt was 3.78% in the second quarter of fiscal 2009 compared to 5.35% in the fourth quarter of fiscal 2007 (the quarter before the crisis started). We expect our cost of debt to increase because short-term market interest rates are at historic lows and we will be charged higher credit spreads as we renew or obtain financing. We discuss our cost of debt in the Market Interest Rate Risk and Sensitivity section.

Maintaining conservative leverage and ample liquidity, having multi-year committed bank credit facilities and term debt with staggered maturities, and our approach to managing credit risk on our finance receivables (as discussed in the Finance Receivables and Asset Quality section) have been integral to our success during this difficult period.

Critical Accounting Policies and Estimates

Applying accounting principles generally accepted in the United States requires judgment, assumptions and estimates to record the amounts in the Consolidated Financial Statements and accompanying notes. We describe the significant accounting policies and methods we use to prepare the Consolidated Financial Statements in Note 1 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended July 31, 2008. Accounting policies involving significant judgment, assumptions and estimates are considered critical accounting policies and are discussed below.

Allowance for Credit Losses

The allowance for credit losses on finance receivables is our estimate of losses inherent in our finance receivables at the balance sheet date. The allowance is difficult to determine and requires significant judgment. The allowance is based on total finance receivables, net charge-off experience, impaired and delinquent finance receivables and our current assessment of the risks inherent in our finance receivables from national and regional economic conditions, industry conditions, concentrations, the financial condition of customers and guarantors, collateral values and other factors. We may need to change the allowance level significantly if unexpected changes in these conditions or factors occur. Increases in the allowance would reduce net income through higher provisions for credit losses. We would need to record a $1.8 million provision for each 0.10% required increase in the allowance. The allowance was $24.8 million (1.38% of finance receivables) at January 31, 2009 including $1.1 million specifically allocated to impaired receivables.

The allowance includes amounts specifically allocated to impaired receivables and an amount to provide for losses inherent in finance receivables that are not impaired (the "general allowance"). We evaluate the fair values of impaired receivables and compare them to the carrying amounts. The carrying amount is the amount receivables are recorded at when we evaluate them and may include prior write-downs or a specific allowance. If our fair value estimate is lower than the carrying amount, we record a write-down or establish a specific allowance depending on (i) how we determined fair value (ii) how certain we are of our estimate and (iii) the level and type of factors and items other than the primary collateral supporting our fair value estimate, such as guarantees and secondary collateral.

To estimate the general allowance, we analyze historical write-down activity to develop percentage loss ranges by risk profile. Risk profiles are assigned to receivables based on past due status and the customers' industry. We do not use a loan grading system. We then adjust the calculated range of losses for expected recoveries and differences between current and historical loss trends and other factors to arrive at the estimated allowance. We record a provision for credit losses if the recorded allowance differs from our current estimate. The adjusted calculated range of losses may differ from actual losses significantly because we use significant estimates.

Non-Performing Assets

We record impaired finance receivables and repossessed equipment (assets received to satisfy receivables) at their current estimated fair value (if less than their carrying amount). We estimate fair value of these non-performing assets by evaluating the market value and condition of the collateral or assets and the expected cash flows of impaired receivables. We evaluate market value based on recent sales of similar equipment, used equipment publications, our market knowledge and information from equipment vendors. Unexpected adverse changes in or incorrect estimates of expected cash flows, market value or the condition of collateral or assets, or time needed to sell equipment would require us to record a write-down. This would lower net income. Non-performing assets totaled $53.6 million (3.0% of finance receivables) at January 31, 2009.

Residual Values

We record residual values on direct financing leases at the lowest of (i) any stated purchase option (ii) the present value at the end of the initial lease term of rentals due under any renewal options or (iii) our projection of the equipment's fair value at the end of the lease. We may not fully realize recorded residual values because of unexpected adverse changes in or incorrect projections of future equipment values. This would lower net income. Residual values totaled $37.6 million (2.1% of finance receivables) at January 31, 2009. Historically, we have realized the recorded residual value on disposition.

Income Taxes

We record a liability for uncertain income tax positions by (i) identifying the uncertain tax positions we take on our income tax returns (ii) determining if these positions would more likely than not be allowed by a taxing authority and (iii) estimating the amount of tax benefit to record if these tax positions pass the more-likely-than-not test. Therefore, we record a liability for tax benefits from positions failing the test and from positions where the full amount of the tax benefits are not expected to be realized. Identifying uncertain tax positions, determining if they pass the test and determining the liability to record requires significant judgment because tax laws are complicated and subject to interpretation, and because we have to assess the likely outcome of hypothetical challenges to these positions by taxing authorities. Actual outcomes of these uncertain tax positions differing from our assessments significantly and taxing authorities examining positions we did not consider uncertain could require us to record additional income tax expense including interest and penalties on any underpayment of tax. This would lower net income. The gross liability recorded for uncertain tax positions was $1.2 million at July 31, 2008 and we do not expect this amount to change in fiscal 2009 significantly.

Stock-Based Compensation

We record compensation expense only for stock-based awards expected to vest. Therefore, we must estimate expected forfeitures of stock awards. This requires significant judgment and an analysis of historical data. We would need to record more compensation expense for stock awards if expected forfeitures exceed actual forfeitures. Our average expected annual rate of forfeitures on all stock-based awards was 7.0% at January 31, 2009.

Results of Operations

Comparison of three months ended January 31, 2009 to three months ended January
31, 2008

      ========================================================================
                                      Three Months Ended
                                             January 31,
      ($ in millions, except per      ------------------
      share amounts)                     2009       2008   $ Change   % Change
      ========================================================================
      Finance income                   $ 40.6     $ 48.7     $ (8.1)       (17)%
      Interest expense                   12.9       20.5       (7.6)       (37)
        Net finance income before
         provision for credit losses     27.7       28.2       (0.5)        (2)
      Provision for credit losses         2.1        0.8        1.3        163
      Gain on debt retirement             1.6         --        1.6        100
      Salaries and other expenses         7.3        6.9        0.4          6
      Provision for income taxes          7.6        7.9       (0.3)        (4)
        Net income                       12.3       12.6       (0.3)        (2)

      Diluted earnings per share         0.49       0.51      (0.02)        (4)
      Basic earnings per share           0.50       0.52      (0.02)        (4)

      Return on equity                   11.3%      12.9%

      Excluding the debt retirement gain:
      -----------------------------------
        Net income                     $ 11.3     $ 12.6     $ (1.3)       (10)%

        Diluted earnings per share       0.45       0.51      (0.06)       (12)
        Basic earnings per share         0.46       0.52      (0.06)       (12)

        Return on equity                 10.4%      12.9%
      ========================================================================

Net income decreased by 2% to $12.3 million in the second quarter of fiscal 2009 from $12.6 million in the second quarter of fiscal 2008. Without the $1.0 million after-tax debt retirement gain, net income decreased by 10%. Net income without the after-tax debt gain decreased because the effects of the 12% decrease in average receivables and higher non-performing assets exceeded the effects of lower short-term market interest rates. We discuss the debt retirement gain in the Liquidity and Capital Resources Section.

Finance income decreased by 17% to $40.6 million in the second quarter of fiscal 2009 from $48.7 million in the second quarter of fiscal 2008 because (i) average finance receivables decreased 12% ($250.0 million) to $1.85 billion from $2.10 billion (ii) the yield on finance receivables decreased to 8.72% from 9.23% mostly due to the prime rate averaging 360 basis points (3.60%) lower and, to a lesser extent, (iii) non-accrual (impaired) receivables were higher. Changes in the prime rate affect the yield on receivables because 9% of our receivables are floating rate and indexed to prime.

Interest expense (incurred on debt used to fund finance receivables) decreased by 37% to $12.9 million in the second quarter of fiscal 2009 from $20.5 million in the second quarter of fiscal 2008 because our cost of debt decreased to 3.78% from 5.00% and our average debt decreased 17% ($274.0 million). Lower short-term market interest rates caused the decrease in our cost of debt because the interest rates on 40% of our debt were indexed to short-term market interest rates. This is discussed in the Market Interest Rate Risk and Sensitivity section.

Net finance income before provision for credit losses on finance receivables decreased to $27.7 million in the second quarter of fiscal 2009 from $28.2 million in the second quarter of fiscal 2008. Net interest margin (net finance income before provision for credit losses expressed as an annualized percentage of average finance receivables) increased to 5.94% from 5.34% because of lower short-term market interest rates.

The provision for credit losses on finance receivables was $2.1 million in the second quarter of fiscal 2009 and $0.8 million in the second quarter of fiscal 2008. The provision for credit losses is the amount needed to change the allowance for credit losses to our estimate of losses inherent in finance receivables. Net charge-offs (write-downs of finance receivables less recoveries) increased to $2.0 million in the second quarter of fiscal 2009 from $0.7 million in the second quarter of fiscal 2008, and the loss ratio (net charge-offs expressed as an annualized percentage of average finance receivables) increased to 0.44% from 0.13%. Net charge-offs have been increasing because of higher non-performing assets, worsening economic conditions and declining collateral values. The allowance and net charge-offs are discussed further in the Finance Receivables and Asset Quality section.

Salaries and other expenses increased by 6% to $7.3 million in the second quarter of fiscal 2009 from $6.9 million in the second quarter of fiscal 2008 because of higher non-performing asset costs and salary increases. The expense ratio (salaries and other expenses expressed as an annualized percentage of average finance receivables) worsened to 1.55% from 1.30% because expenses increased and receivables decreased. The efficiency ratio (expense ratio expressed as a percentage of net interest margin) worsened to 26.1% from 24.3% because expenses increased and net finance income before provision for credit losses decreased.

Diluted earnings per share decreased by 4% to $0.49 per share in the second quarter of fiscal 2009 from $0.51 per share in the second quarter of fiscal 2008, and basic earnings per share decreased by 4% to $0.50 per share from $0.52 per share. The percentage decreases in diluted and basic earnings per share were higher than the percentage decrease in net income because of prior stock option exercises. The $1.0 million after-tax debt retirement gain increased diluted and basic earnings per share by $0.04 in the second quarter of fiscal 2009. Without this gain, diluted and basic earnings per share each decreased by 12%.

The amounts of net income, diluted and basic earnings per share and return-on-equity excluding the $1.0 million after-tax debt retirement gain are non-GAAP financial measures. We believe presenting these financial measures is useful to investors because they provide consistency and comparability with our operating results for the prior period and a better understanding of the changes and trends in our operating results.

Comparison of six months ended January 31, 2009 to six months ended January 31,

2008

      ========================================================================
                                        Six Months Ended
                                             January 31,
      ($ in millions, except per       -----------------
      share amounts)                     2009       2008   $ Change   % Change
      ========================================================================
      Finance income                   $ 83.6     $ 98.3    $ (14.7)       (15)%
      Interest expense                   28.3       42.6      (14.3)       (34)
        Net finance income before
         provision for credit losses     55.3       55.7       (0.4)        (1)
      Provision for credit losses         3.5        1.2        2.3        192
      Gain on debt retirement             1.6         --        1.6        100
      Salaries and other expenses        14.4       13.3        1.1          8
      Provision for income taxes         15.0       15.9       (0.9)        (6)
        Net income                       24.0       25.3       (1.3)        (5)

      Diluted earnings per share         0.96       1.01      (0.05)        (5)
      Basic earnings per share           0.98       1.03      (0.05)        (5)

      Return on equity                   11.2%      12.9%

      Excluding the debt retirement gain:
      -----------------------------------
        Net income                     $ 23.0     $ 25.3    $  (2.3)        (9)%

        Diluted earnings per share       0.92       1.01      (0.09)        (9)
        Basic earnings per share         0.94       1.03      (0.09)        (9)

        Return on equity                 10.7%      12.9%
      ========================================================================

Net income decreased by 5% to $24.0 million in the first half of fiscal 2009 from $25.3 million in the first half of fiscal 2008. Without the $1.0 million after-tax debt retirement gain, net income decreased by 9%. Net income without the after-tax debt gain decreased because the effects of the 11% decrease in average receivables and higher non-performing assets exceeded the effects of lower short-term market interest rates.

Finance income decreased by 15% to $83.6 million in the first half of fiscal 2009 from $98.3 million in the first half of fiscal 2008 because (i) average finance receivables decreased 11% ($230.0 million) to $1.88 billion from $2.11 billion (ii) the yield on finance receivables decreased to 8.81% from 9.25% mostly due to the prime rate averaging 330 basis points (3.30%) lower and, to a lesser extent, (iii) non-accrual receivables were higher.

Interest expense decreased by 34% to $28.3 million in the first half of fiscal 2009 from $42.6 million in the first half of fiscal 2008 because our cost of debt decreased to 4.03% from 5.17% and our average debt decreased 15% ($245.0 million). Lower short-term market interest rates caused the decrease in our cost of debt because the interest rates on 40% of our debt were indexed to short-term market interest rates.

Net finance income before provision for credit losses on finance receivables decreased to $55.3 million in the first half of fiscal 2009 from $55.7 million in the first half of fiscal 2008. Net interest margin increased to 5.82% from 5.24% because of lower short-term market interest rates.

The provision for credit losses on finance receivables was $3.5 million in the first half of fiscal 2009 and $1.2 million in the first half of fiscal 2008. Net charge-offs increased to $3.4 million in the first half of fiscal 2009 from $1.1 million in the first half of fiscal 2008, and the loss ratio increased to 0.36% from 0.10%. Net charge-offs have been increasing because of higher non-performing assets, worsening economic conditions and declining collateral values.

Salaries and other expenses increased by 8% to $14.4 million in the first half of fiscal 2009 from $13.3 million in the first half of fiscal 2008 because of higher non-performing asset costs and, to a lesser extent, salary increases. The expense ratio worsened to 1.52% from 1.26% because expenses increased and receivables decreased. The efficiency ratio worsened to 26.1% from 24.0% because expenses increased and net finance income before provision for credit losses decreased.

Diluted earnings per share decreased by 5% to $0.96 per share in the first half of fiscal 2009 from $1.01 per share in the first half of fiscal 2008, and basic earnings per share decreased by 5% to $0.98 per share from $1.03 per share. The $1.0 million after-tax debt retirement gain increased diluted and basic earnings per share by $0.04 in the first half of fiscal 2009. Without this gain, diluted and basic earnings per share each decreased by 9%.

Finance Receivables and Asset Quality

      We discuss trends and characteristics of our finance receivables and our
approach to managing credit risk in this section. The key aspect is asset
quality. Asset quality statistics measure our underwriting standards, skills and
policies and procedures and can indicate the direction of future net charge-offs
and non-performing assets.

      ========================================================================
                                   January 31,   July 31,
      ($ in millions)                   2009 *     2008 *   $ Change  % Change
      ========================================================================
      Finance receivables             $1,804.0   $1,940.8    $(136.8)       (7)%
      Allowance for credit losses         24.8       24.8         --        --
      Non-performing assets               53.6       46.7        6.9        15
      Delinquent finance receivables      26.6       22.9        3.7        16
      Net charge-offs                      3.4        2.2        1.2        58

      As a percentage of receivables:
      -------------------------------
      Allowance for credit losses         1.38%      1.28%
      Non-performing assets               2.97       2.41
      Delinquent finance receivables      1.47       1.18
      Net charge-offs (loss ratio)        0.36       0.22
      ========================================================================

Finance receivables comprise installment sale agreements and secured loans (collectively referred to as loans) and direct financing leases. Loans were 91% ($1.64 billion) of finance receivables and leases were 9% ($159 million) at January 31, 2009. Finance receivables decreased $136.8 million or 7% in the first half of fiscal 2009 because of lower originations.

We originated $126.0 million of finance receivables in the second quarter of fiscal 2009 compared to $225.0 million in the second quarter of fiscal 2008, and $351.0 million in the first half of fiscal 2009 compared to $484.0 million in the first half of fiscal 2008. Originations have been decreasing because recessionary economic conditions have reduced demand for equipment financing significantly and, to a lesser extent, because we are approving transactions selectively to preserve asset quality. We collected $205.0 million of finance receivables and repossessions in the second quarter of fiscal 2009 compared to $273.0 million in the second quarter of fiscal 2008, and $478.0 million in the first half of fiscal 2009 compared to $531.0 million in the first half of fiscal 2008. Collections decreased because of fewer prepayments and the decrease in receivables.

Our primary focus is the credit quality of our receivables. We manage our credit risk by adhering to disciplined and sound underwriting policies and procedures, by monitoring our receivables closely, by handling non-performing accounts effectively and by managing the size of our receivables portfolio. Our underwriting policies and procedures require a first lien on equipment financed. We focus on financing equipment with a remaining useful life longer than the term financed, historically low levels of technological obsolescence, use in more than one type of business, ease of access and transporting, and broad, established resale markets. Securing our receivables with equipment possessing these characteristics can mitigate potential net charge-offs. We may also obtain additional equipment or other collateral, third-party guarantees, advance payments or hold back a portion of the amount financed. We do not finance or lease aircraft or railcars, computer related equipment, telecommunications equipment or equipment located outside the United States, and we do not lend to consumers.

Our underwriting policies also limit our credit exposure with any customer. The limit was $48.0 million at January 31, 2009. Our ten largest customers accounted for 7.0% ($126.0 million) of total finance receivables at January 31, 2009 compared to 6.4% ($125.0 million) at July 31, 2008.

. . .