Healthcare Services Group, Inc. Annual Report 2005

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FY2005 Annual Report · Healthcare Services Group, Inc.

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Healthcare Services Group, Inc.

Since its formation in 1977, Healthcare has been in the forefront

of providing housekeeping, laundry, linen, facility maintenance

and more recently, food services resulting in a current client base

of over 1,700 nursing homes, retirement facilities, rehabilitation

centers and hospitals.

Contents:

Letter to Shareholders

Company Profile

Selected Financial Data

Management’s Discussion and Analysis

Financial Statements

Notes to Financial Statements

Management’s Annual Report On Internal Control
Over Financial Reporting

Report of Independent Registered
Public Accounting Firm

Report of Independent Certified Public Accountants

Financial Highlights

(in thousands except per share data and employees)
Years Ended December 31,

2005

2004

2003

2002

2001

Healthcare Services Group, Inc.

Revenues
Net income

Basic earnings per common share

Diluted earnings per common share

Cash Dividends per common share

Weighted average number of common

shares outstanding for basic EPS

Weighted average number of common

shares outstanding for diluted EPS

Working capital

Total assets

Stockholders’ equity

Book value per common share

Employees

$ 466,291
$ 19,096

.71

.67

.30

$ 442,568
$ 14,699
.561
.531
.171

$ 379,718
$ 10,860
.421
.411
.061

$ 328,500
$ 8,631
.341
.331
–

$ 284,190
$ 7,035
.291
.281
–

26,921

26,2211

25,5741

25,3421

24,5881

28,320

27,6601

26,6821

26,3011

24,9251

As of December 31,

2005

2004

2003

2002

2001

$ 142,535

$ 125,012

$ 112,073

$ 96,117

$ 84,089

$ 188,430

$ 166,964

$ 158,328

$ 134,296

$ 120,790

$ 148,163

5.47

20,400

$ 131,460
5.011
19,900

$ 121,198
4.671
18,400

$ 107,881
4.291
16,100

$ 98,943
3.971
15,900

(1) Adjusted to reflect the 3-for-2 Stock Split paid in the form of a 50% Common Stock Dividend on May 2, 2005.

Net Income
(in thousands)

Book Value per
Common Share

Basic Earnings per
Common Share

Revenues
(in thousands)

(cid:18)(cid:21)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:18)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:17)(cid:21)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:17)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:21)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:16)

(cid:17)(cid:16)

(cid:24)

(cid:22)

(cid:20)

(cid:18)

(cid:16)

(cid:17)(cid:14)(cid:16)

(cid:16)(cid:14)(cid:24)

(cid:16)(cid:14)(cid:22)

(cid:16)(cid:14)(cid:20)

(cid:16)(cid:14)(cid:18)

(cid:16)(cid:14)(cid:16)

(cid:21)(cid:16)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:20)(cid:16)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:19)(cid:16)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:18)(cid:16)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:17)(cid:16)(cid:16)(cid:12)(cid:16)(cid:16)(cid:16)

(cid:16)

(cid:18)(cid:16)(cid:16)(cid:17)

(cid:18)(cid:16)(cid:16)(cid:18)

(cid:18)(cid:16)(cid:16)(cid:19)

(cid:18)(cid:16)(cid:16)(cid:20)

(cid:18)(cid:16)(cid:16)(cid:21)

(cid:18)(cid:16)(cid:16)(cid:17)

(cid:18)(cid:16)(cid:16)(cid:18)

(cid:18)(cid:16)(cid:16)(cid:19)

(cid:18)(cid:16)(cid:16)(cid:20)

(cid:18)(cid:16)(cid:16)(cid:21)

(cid:18)(cid:16)(cid:16)(cid:17)

(cid:18)(cid:16)(cid:16)(cid:18)

(cid:18)(cid:16)(cid:16)(cid:19)

(cid:18)(cid:16)(cid:16)(cid:20)

(cid:18)(cid:16)(cid:16)(cid:21)

(cid:18)(cid:16)(cid:16)(cid:17)

(cid:18)(cid:16)(cid:16)(cid:18)

(cid:18)(cid:16)(cid:16)(cid:19)

(cid:18)(cid:16)(cid:16)(cid:20)

(cid:18)(cid:16)(cid:16)(cid:21)

We are pleased to report that again in 2005 our Company’s financial performance

reached new heights.

Dear Shareholders:

n Revenues:

Our extraordinary record of consistent performance is primar-

$466,291,000- a 5% increase over 2004 revenues

ily a result of our focus on maintaining a commitment to every one

n Net income:

of our clients to deliver a service of the highest quality with an em-

$19,096,000- a 30% increase over 2004 net income

phasis on cost containment. We are able to accomplish this through

n Diluted earnings per common share:

fostering a partnership relationship between our management and

$.67- a 26% increase over 2004 diluted earnings per common
share

that of our clients. Our decentralized management system not
only gives our people a sense of direct responsibility and ownership

n Total cash dividend payments in 2005: $.30 per common
share- a 76% increase over total cash dividend payments in

2004

in addressing clients’ needs, but more importantly positions our

management people, as the Company representative, in front of the

client on a consistent basis. It is this ongoing interaction between

our management and the client which is the essence of our business

These record results were achieved through revenue and net

model of having our clients see us as a partner in their day-to-day

income growth in both our housekeeping and food operating seg-

operation. We realize that a primary goal of our clients when engag-

ments. Most significantly, we are pleased by the 36% increase in the

ing us is to have their overall operations run more efficiently. It is

food segment’s 2005 net income compared to 2004 net income.

our ability to consistently and reliably provide our services which

We believe this growth is a sign of the improved utilization and

fosters our partnership with our clients and helps them meet their

maturity of our food segment management organization and this

goals.

improvement should continue.

All of the management and workforce at Healthcare begin

As an outcome of 2005’s record results and our strong financial

2006 with enthusiasm and a commitment to remain focused on the

position, the Board of Directors increased quarterly cash dividend

strategies which have worked so well for us during the past 30 years

payments in every quarter of 2005. This trend has continued into

enabling us to become the provider of choice for our services within

2006, as the Board of Directors declared a quarterly cash dividend

the long-term care industry. The results and business accounts

payment of $.10 per common share which was paid on February

reported in the following pages enable us to proudly state that we

13, 2006. This quarterly cash dividend was our eleventh consecutive

are confident we can maintain strong business growth and increase

quarterly cash dividend payment, as well as the tenth consecutive

shareholder value.

increase since our initiation of quarterly cash dividend payments.

The Company has also expended approximately $29,000,000,

including almost $4,000,000 in 2005, to increase shareholder value

by buying back almost 6,000,000 shares of our common stock

(adjusted for stock splits) since instituting a “Share Buy-Back” pro-

Daniel P. McCartney

gram. As of December 31, 2005, we have remaining approximately

Chairman & Chief Executive Officer

1,300,000 shares of common stock authorized for buy-back pursu-

ant to prior Board of Directors’ approvals.

Thomas A. Cook

President & Chief Operating Officer

s
e
c
v
r
e
S

r
u
O

Laundry and Linen services consist of laundering
and processing the personal clothing of residents
and patients, as well as the providing, collecting and
laundering of sheets, pillow cases, blankets and other
linen items used in a health care facility. Additionally,
we work closely with the facility to design, install,
operate and maintain an on-premise laundry.

Facility maintenance & plant management services
consist of the repair and preventive maintenance of
the building and equipment at a specific facility.

Housekeeping services consist of the cleaning,
disinfecting and sanitizing of all areas in the facility,
including resident and patient rooms, auxiliary
areas, and main access areas such as the lobby,
public rest rooms, offices and corridors. Our on-site
management team provides continuous employee
supervision, training and evaluation. We also
conduct periodic testing for the purpose of infection
control.

Food services consist of the development of a menu
that meets the residents’ dietary needs, purchasing
and preparing the food to assure the residents and
patients receive an appetizing meal, and participation
in monitoring of the residents’ ongoing nutrition
status. On-site management is responsible for all
daily food service activities with regular support being
provided by a district manager specializing in food
service and a registered dietitian.

The Market:

Our clients have experienced

unprecedented growth in their industry,

with expectations that it will continue

at an accelerated pace. The United States

Census Bureau states that there are

currently over 35 million citizens over age

(cid:17)(cid:25)(cid:16)(cid:16)

(cid:17)(cid:25)(cid:18)(cid:16)

(cid:17)(cid:25)(cid:20)(cid:16)

(cid:17)(cid:25)(cid:22)(cid:16)

(cid:17)(cid:25)(cid:24)(cid:16)

(cid:18)(cid:16)(cid:16)(cid:16)

(cid:18)(cid:16)(cid:18)(cid:16)

(cid:18)(cid:16)(cid:20)(cid:16)

(cid:17)(cid:25)(cid:17)(cid:16)

(cid:17)(cid:25)(cid:19)(cid:16)

(cid:17)(cid:25)(cid:21)(cid:16)

(cid:17)(cid:25)(cid:23)(cid:16)

(cid:17)(cid:25)(cid:25)(cid:16)

(cid:18)(cid:16)(cid:17)(cid:16)

(cid:18)(cid:16)(cid:19)(cid:16)

(cid:18)(cid:16)(cid:21)(cid:16)

65, which represents approximately 13

percent of the United States population.

Number of People age 65 and over 1900-2000,
projected 2010-2050

(cid:22)(cid:21)(cid:0)(cid:65)(cid:78)(cid:68)(cid:0)(cid:47)(cid:86)(cid:69)(cid:82)

(cid:24)(cid:21)(cid:0)(cid:65)(cid:78)(cid:68)(cid:0)(cid:47)(cid:86)(cid:69)(cid:82)

(cid:48)(cid:82)(cid:79)(cid:74)(cid:69)(cid:67)(cid:84)(cid:69)(cid:68)

(cid:17)(cid:16)(cid:16)

(cid:83)
(cid:78)
(cid:79)

(cid:73)
(cid:76)
(cid:76)
(cid:73)

(cid:77)

(cid:25)(cid:16)

(cid:24)(cid:16)

(cid:23)(cid:16)

(cid:22)(cid:16)

(cid:21)(cid:16)

(cid:20)(cid:16)

(cid:19)(cid:16)

(cid:18)(cid:16)

(cid:17)(cid:16)

(cid:16)

Opportunity for Expansion

(cid:46)(cid:85)(cid:82)(cid:83)(cid:73)(cid:78)(cid:71)(cid:0)(cid:40)(cid:79)(cid:77)(cid:69)(cid:83)(cid:0)(cid:85)(cid:78)(cid:68)(cid:69)(cid:82)(cid:0)(cid:35)(cid:79)(cid:78)(cid:84)(cid:82)(cid:65)(cid:67)(cid:84)(cid:0)(cid:87)(cid:73)(cid:84)(cid:72)(cid:0)(cid:40)(cid:35)(cid:51)(cid:39)

(cid:52)(cid:79)(cid:84)(cid:65)(cid:76)(cid:0)(cid:53)(cid:51)(cid:0)(cid:46)(cid:85)(cid:82)(cid:83)(cid:73)(cid:78)(cid:71)(cid:0)(cid:40)(cid:79)(cid:77)(cid:69)(cid:83)

Healthcare Services Group, Inc. has witnessed a major reshaping

The increased demand for facilities providing post-acute/long-

of the methods of delivering long-term care and other associated

term care is demonstrated by the fact that the U.S. Census Bureau

needs of the elderly, developmentally disabled or infirmed during

predicts that the elderly population is projected to double between

its thirty years of service to the health care industry. The elderly

the years 2000 and 2040. Additionally, nearly 50 percent of the over-

population is expected to increase to approximately 70 million

85 population segment, which is the fastest growing segment of the

or more than 20 percent of the total population by the year 2030.

elderly population, currently require some type of long-term care

Integral to this growth of the elderly population is their need for

while approximately 25 percent of this age segment currently reside

long-term care. As more of the population live extended lives, their

in nursing homes. The industry in which we operate is affected by

potential for the need of some form of post-acute care is more

many other factors besides the growth in the elderly population.

essential.

Most significant is the various economic and political pressures

present in today’s health care environment. Many operators of

health care facilities are strained, financially and in providing

services, because of the new reformed health care environment that

has developed.

Our Goal is to Provide the best service in the industry

A health care facility derives many benefits from operating a

spotlessly clean, aesthetically pleasing environment. Our staff

is thoroughly trained to perform housekeeping, laundry, linen,

facility maintenance and food service responsibilities with skill

and sensitivity. Stringent quality-assurance standards insure that a

facility will receive the most professional services in the industry.

Our Guidelines:

Develop a strong and well coordinated management team

Concentrate on what we do best

The key to our client retention rate and orderly geographic

Companies which diversify outside their core business often

expansion has been our ability to assemble the finest group of

suffer diminishing returns. Healthcare Services Group, Inc., has

managers in the industry. Clients, who receive daily support from

prospered by providing exemplary housekeeping, laundry, linen,

on-site management, are also actively supported by a Company

facility maintenance and food services to an increasing number of

District Manager who is in close proximity to the client. The

satisfied clients. This is what we always have done and what we

development of experienced management back-up is reassuring to

will continue to do.

owners and administrators. Reducing client costs while improving

overall quality is a most challenging assignment. This objective is

met by standardizing operating systems, maintaining strict controls

through a quality-assurance program and planning efficient

production schedules.

Reach

Corporate Office

Divisional Office

Regional Office

Healthcare Services Group, Inc. is a leader in providing contractual housekeeping, laundry, linen, facility

maintenance and food services for the health care industry. Services are provided to 1,700 nursing

homes, rehabilitation facilities, retirement centers, and hospitals in 45 states and Canada.

Partnership responsibility means thorough understanding of our client’s needs to deliver high quality

care to residents and patients of health care facilities.

The following discussion and analysis should be read in conjunction with the Financial Statements and Notes thereto.

SELECTED FINANCIAL DATA

The selected ﬁnancial data presented below should be read in conjunction with, and is qualiﬁed in its entirety by reference to the
Financial Statements and Notes thereto.

(in thousands except for per share data and employees)

Years Ended December 31:

2005

2004

2003

2002

2001

Revenues

Net income

Basic earnings per common share
Diluted earnings per common share

Cash dividends per common share
Weighted average number of common

shares outstanding for basic EPS

Weighted average number of common
shares outstanding for diluted EPS

As of December 31:

Working Capital
Total Assets

Stockholders’ Equity
Book Value Per Common Share

Employees

$466,291

$ 19,096

$
$

.71
.67

.30

$442,568

$379,718

$328,500

$284,190

$
$

$ 14,699
.561
.531
.171

$ 10,860
.421
.411
.061

$
$

8,631
.341
.331
—

$
$

7,035
.291
.281
—

26,921

26,2211

25,5741

25,3421

24,5881

28,320

27,6601

26,6821

26,3011

24,9251

$142,535
$188,430

$148,163
5.47
$

20,400

$125,012
$166,964

$131,460
5.011
$
19,900

$112,073
$158,328

$121,198
4.671
18,400

$ 96,117
$134,296

$107,881
4.291
16,100

$ 84,089
$120,790

$ 98,943
3.971
15,900

1Adjusted to reﬂect the 3 for 2 Stock Split paid in the form of a 50% Common Stock Dividend on May 2, 2005

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Cautionary Statement Regarding Forward

Looking Statements

This report includes forward-looking statements that are subject to risks and uncertainties that could cause actual results or

objectives to differ materially from those projected. We undertake no obligation to publicly update or revise any forward-looking

statements, whether as a result of new information, future events or otherwise. Such risks and uncertainties include, but are not
limited to, risks arising from our providing services exclusively to the health care industry, primarily providers of long-term care;

credit and collection risks associated with this industry; one client accounting for approximately 19% of revenues in 2005 (the
client entered into a merger agreement on August 16, 2005 and the transaction is expected to close in the ﬁrst quarter of 2006-

see Note 1, ‘‘Major Client’’ in the following Notes to Consolidated Financial Statements); our claims experience related to

workers’ compensation and general liability insurance; the effects of changes in, or interpretations of laws and regulations
governing the industry, including state and local regulations pertaining to the taxability of our services; and the risk factors

described in our Form 10-K ﬁled with the Securities and Exchange Commission for the year ended December 31, 2005 and in
Part I thereof under ‘‘Government Regulation of Clients’’, ‘‘Competition’’ and ‘‘Service Agreements/Collections’’. Many of our

clients’ revenues are highly contingent on Medicare and Medicaid reimbursement funding rates, which have been and continue to

be adversely affected by the change in Medicare payments under the 1997 enactment of the Medicare Prospective Payment
System. That change, and the lack of substantive reimbursement funding rate reform legislation, as well as other trends in the

long-term care industry have resulted in certain of our clients ﬁling for bankruptcy protection. Others may follow. Any decisions
by the government to discontinue or adversely modify legislation related to reimbursement funding rates will have a material

adverse effect on our clients. These factors, in addition to delays in payments from clients have resulted in and could continue to
result in signiﬁcant additional bad debts in the near future. Additionally, our operating results would be adversely affected if

unexpected increases in the costs of labor and labor related costs, materials, supplies and equipment used in performing services

could not be passed on to our clients.

In addition, we believe that to improve our ﬁnancial performance we must continue to obtain service agreements with new
clients, provide new services to existing clients, achieve modest price increases on current service agreements with existing clients

and maintain internal cost reduction strategies at our various operational levels. Furthermore, we believe that our ability to

sustain the internal development of managerial personnel is an important factor impacting future operating results and
successfully executing projected growth strategies.

Results of Operations

The following discussion is intended to provide the reader with information that will be helpful in understanding our ﬁnancial

statements including the changes in certain key items in comparing ﬁnancial statements period to period. We also intend to

provide the primary factors that accounted for those changes, as well as a summary of how certain accounting principles affect
our ﬁnancial statements. In addition, we are providing information about the ﬁnancial results of our two operating segments to

further assist in understanding how these segments and their results affect our consolidated results of operations. This discussion
should be read in conjunction with our ﬁnancial statements as of December 31, 2005 and the year then ended and the notes

accompanying those ﬁnancial statements.

Overview

We provide housekeeping, laundry, linen, facility maintenance and food services to the health care industry, including nursing

homes, retirement complexes, rehabilitation centers and hospitals located throughout the United States. We believe that we are
the largest provider of housekeeping and laundry services to the long-term care industry in the United States, rendering such

services to approximately 1,700 facilities in 45 states as of December 31, 2005. Although we do not directly participate in any
government reimbursement programs, our clients’ reimbursements are subject to government regulation. Therefore, they are

directly affected by any legislation relating to Medicare and Medicaid reimbursement programs.

We provide our services primarily pursuant to full service agreements with our clients. In such agreements, we are responsible for

the management and hourly employees located at our clients’ facilities. We also provide services on the basis of a
management-only agreement for a very limited number of clients. Our agreements with clients typically provide for a one year

service term, cancelable by either party upon 30 to 90 days notice after the initial 90-day period.

We are organized into two reportable segments; housekeeping, laundry, linen and other services (‘‘Housekeeping’’), and food

services (‘‘Food’’).

The services provided by Housekeeping consist primarily of the cleaning, disinfecting and sanitizing of patient rooms and

common areas of a client’s facility, as well as the laundering and processing of the personal clothing belonging to the facility’s
patients. Also within the scope of this segment’s service is the laundering and processing of the bed linens, uniforms and other

assorted linen items utilized by a client facility.

Food, which began operations in 1997, consists of providing for the development of a menu that meets the patient’s dietary

needs, and the purchasing and preparing of the food for delivery to the patients.

Additionally, we operate two wholly-owned subsidiaries, HCSG Supply, Inc. (‘‘Supply’’) and Huntingdon Holdings, Inc.

(‘‘Huntingdon’’). Supply purchases, warehouses and distributes the supplies and equipment used in providing our Housekeeping
segment services. Huntingdon invests our cash and cash equivalents.

Consolidated Operations

The following table sets forth, for the years indicated, the percentage which certain items bear to consolidated revenues:

Revenues
Operating costs and expenses:

Costs of services provided
Selling, general and

administration

Investment and interest income

Income before income taxes
Income taxes

Relation to Consolidated Revenues
Years Ended December 31,

2005

2004

2003

100.0%

87.1

87.8

88.1

7.0

6.6
2.5

7.1

5.4
2.0

7.6

4.7
1.8

Net income

4.1%

3.4%

2.9%

Subject to the factors noted in the Cautionary Statement Regarding Forward Looking Statements included in this report, we
anticipate our ﬁnancial performance in 2006 to be comparable to the 2005 percentages presented in the above table as they relate

to consolidated revenues.

Housekeeping is our largest and core reportable segment, representing approximately 80% of 2005 consolidated revenues. Food

revenues represented approximately 20% of 2005 consolidated revenues.

Although there can be no assurance thereof, we believe that in 2006 each of Housekeeping’s and Food’s revenues, as a percentage

of consolidated revenues, will remain approximately the same as their respective 2005 percentages noted above. Furthermore, we
expect the sources of growth in 2006 for the respective operating segments will be primarily the same as historically experienced.

Accordingly, although there can be no assurance thereof, the growth in Food is expected to come from our current Housekeeping
client base, while growth in Housekeeping will primarily come from obtaining new clients.

2005 Compared with 2004

The following table sets forth 2005 income statement key components that we use to evaluate our ﬁnancial performance on a

consolidated and reportable segment basis, as well as the percentage increases of each compared to 2004 amounts.

Consolidated

Percent
increase

Corporate and
eliminations

Reportable Segments

Housekeeping

Food

Amount

%incr

Amount

%incr

Revenues

$466,291,000

5.4%

$ (1,706,000)

$375,133,000

4.9% $92,864,000

Cost of services provided

406,114,000

4.5

(27,340,000)

343,224,000

4.5

90,230,000

6.4%

5.7

Selling, general and
administrative

Income before income taxes

Revenues

32,576,000

30,799,000

3.3

29.9

32,576,000

—

(3,744,000)

31,909,000

8.8

2,634,000

36.2

Consolidated
Consolidated revenues increased 5.4% to $466,291,000 in 2005 compared to $442,568,000 in 2004 as a result of the factors

discussed below under Reportable Segments.

We have one client, a nursing home chain (‘‘Major Client’’), which in 2005 and 2004 accounted for 19% and 20%, respectively,

of consolidated revenues. At both December 31, 2005 and 2004 amounts due from such client represented less than 1% of our
accounts receivable balance. According to public ﬁlings, the client entered into a merger agreement on August 16, 2005 and the

transaction is expected to close in the ﬁrst quarter of 2006. Although we expect to continue our relationship with this client’s
successor, there can be no assurance thereof, and the loss of such client would have a material adverse effect on our consolidated

results of operations. Additionally, if such client’s successor changes its payment terms it would increase our accounts receivable

balance and have a material adverse effect on our cash ﬂows and cash and cash equivalents.

Reportable Segments
Housekeeping’s 4.9% net growth in reportable segment revenues is primarily a result of an increase in service agreements entered

into with new clients.

Food’s 6.4% net growth in reportable segment revenues is a result of providing this service to an increasing number of existing

Housekeeping clients.

We derived 18% and 27%, respectively, of Housekeeping and Food’s 2005 revenues from our Major Client.

Costs of services provided

Consolidated

Cost of services provided, on a consolidated basis, as a percentage of consolidated revenues for 2005 decreased to 87.1 % from
87.8 % in 2004. The following table provides a comparison of the primary cost of services provided-key indicators that we

manage on a consolidated basis in evaluating our ﬁnancial performance.

Cost of Services Provided-Key Indicators

2005%

2004%

(Decr)%

Bad debt provision

Workers’ compensation and general

liability insurance

3.9

4.0

(.5)

(.1)

The decrease in bad debt provision resulted primarily from improved collection experience. The workers’ compensation and
liability insurance expense decrease is primarily a result of a current reduction in the average claim cost.

Reportable Segments
Cost of services provided for Housekeeping, as a percentage of Housekeeping revenues, for 2005 decreased to 91.5% from 91.8%

in 2004. Cost of services provided for Food, as a percentage of Food revenues, for 2005 decreased to 97.2% from 97.8% in 2004.

The following table provides a comparison of the primary cost of services provided-key indicators, as a percentage of the

respective segment’s revenues, that we manage on a reportable segment basis in evaluating our ﬁnancial performance:

Cost of Services Provided-Key Indicators

2005%

2004%

Incr (Decr)%

Housekeeping labor and other labor costs
Housekeeping segment supplies

Food labor and other labor costs

Food segment supplies

82.4
5.5

54.9

38.6

82.7
5.2

54.9

38.7

(.3)
.3

—

(.1)

The decrease in Housekeeping labor and other labor costs, as a percentage of Housekeeping revenues, resulted primarily from
efﬁciencies achieved. The increase in Housekeeping supplies resulted primarily from vendor price increases.

The minor decrease in Food segment supplies, as a percentage of Food segment revenues, is a result of price decreases in vendor

purchasing agreements.

Consolidated Selling, General and Administrative Expense

Consistent with our 5.4% growth in consolidated revenues, selling, general and administrative expenses increased by $1,053,000.
However, as a percentage of total consolidated revenues, these expenses decreased to 7.0% in the 2005 as compared to 7.1% in

2004. The decrease is primarily attributable to our ability to control these expenses and comparing them to a greater revenue base
in the current period.

Income before Income Taxes
Consolidated

As a result of the discussion above related to revenues and expenses, consolidated income before income taxes for 2005 increased

to 6.6 %, as a percentage of consolidated revenues, compared to 5.4% in 2004.

Reportable Segments
Housekeeping’s 8.8% increase in income before income taxes is attributable to the improvement in the gross proﬁt earned at the

client facility level and the gross proﬁt earned on the 4.9% increase in reportable segment revenues.

Food’s income before income taxes increased 36.2% on a reportable segment basis which is primarily attributable to an

improvement in the gross proﬁt earned at the client facility level and the gross proﬁt earned on the 6.4% increase in reportable
segment revenues.

Consolidated Investment and Interest Income
Investment and interest income, as a percentage of consolidated revenues, was .7% in 2005 compared to .3% in 2004. The

increase is attributable to improved rates of return on the higher cash and cash equivalents’ average balance and the increase in
market value of the investments held in our Deferred Compensation Fund.

Consolidated Income Taxes
Our effective tax rate at both December 31, 2005 and 2004 was 38%. Absent any signiﬁcant change in federal, or state and local

tax laws, we expect our effective tax rate for 2006 to be approximately the same as realized in 2005. Our 38% effective tax rate

differs from the federal income tax statutory rate principally because of the effect of state and local income taxes.

Consolidated Net Income
As a result of the matters discussed above, consolidated net income for 2005 increased to 4.1%, as a percentage of consolidated

revenues, compared to 3.4% in 2004.

2004 Compared with 2003

The following table sets forth for 2004 income statement key components that we use to evaluate our ﬁnancial performance on a
consolidated and reportable segment basis, as well as the percentage increases (decreases) of each compared to 2003 amounts.

Consolidated

Percent
increase

Corporate and
eliminations

Reportable Segments

Housekeeping

Food

Amount

%incr

Amount

%incr (decr)

Revenues

$442,568,000

16.6%

$ (2,495,000)

$357,754,000

12.3% $87,309,000

388,668,000

16.2

(25,125,000)

328,418,000

11.3

85,375,000

40.4%

41.8

31,523,000
23,706,000

8.5
35.3

31,523,000
(7,564,000)

—
29,336,000

25.6

—
1,934,000

(1.5)

Cost of services provided
Selling, general and

administrative

Income before income taxes

Revenues
Consolidated

Consolidated revenues increased 16.6% to $442,568,000 in 2004 compared to $379,718,000 in 2003 as a result of the factors
discussed below under Reportable Segments.

Our Major Client accounted for 20% and 23% of consolidated revenues in 2004 and 2003, respectively.

Reportable Segments
Housekeeping’s 12.3% net growth in reportable segment revenues is primarily a result of an increase in service agreements entered

into with new clients.

Food’s 40.4% net growth in reportable segment revenues is a result of providing this service to an increasing number of existing
Housekeeping clients.

We derived 19% and 27%, respectively, of the Housekeeping and Food’s 2004 revenues from our Major Client.

Costs of services provided

Consolidated

Cost of services provided, on a consolidated basis, as a percentage of consolidated revenues in 2004 decreased slightly to 87.8 %
from 88.1 % in 2003. The following table provides a comparison of the primary cost of services provided-key indicators that we

manage on a consolidated basis in evaluating our ﬁnancial performance:

Cost of Services Provided-Key Indicators

2004%

2003%

Incr (Decr)%

Bad debt provision

Workers’ compensation and general

liability insurance

4.0

1.2

4.6

(.4)

(.6)

The decrease in bad debt provision resulted primarily from improved collection experience. The decrease in workers’
compensation and general liability insurance is primarily a result of a current reduction in average claim cost.

Reportable Segments

Cost of services provided for Housekeeping, as a percentage of Housekeeping revenues, for 2004 decreased to 91.8% from 92.7%
in 2003. Cost of services provided for Food, as a percentage of Food revenues, for 2004 increased to 97.8% from 96.8% in 2003.

The following table provides a comparison of the primary cost of services provided-key indicators, as a percentage of the

respective segment’s revenues, which we manage on a reportable segment basis in evaluating our ﬁnancial performance:

Cost of Services Provided-Key Indicators

2004%

2003%

Incr (Decr)%

Housekeeping labor and other labor costs

Housekeeping segment supplies
Food labor and other labor costs

Food segment supplies

82.7

5.2
54.9

38.7

83.7

4.7
53.7

39.0

(1.0)

.5
1.2

(.3)

The decrease in Housekeeping labor and other labor costs, as a percentage of Housekeeping revenues, resulted primarily from

efﬁciencies achieved. The increase in Housekeeping supplies resulted primarily from vendor price increases.

The 1.2% increase in Food labor and other labor costs, as a percentage of Food revenues, resulted primarily from inefﬁciencies

experienced in the management of these costs in connection with this segment’s 40.4% growth in revenues. The decrease in Food
supplies, as a percentage of Food revenues, is a result of price decreases in vendor purchasing agreements.

Consolidated Selling, General and Administrative Expense
Consistent with our 16.6% growth in consolidated revenues, selling, general and administrative expenses increased by $2,478,000.

However, as a percentage of total consolidated revenues, these expenses decreased to 7.1% in 2004 as compared to 7.6% in 2003.

The decrease is primarily attributable to our ability to control these expenses and comparing them to a greater revenue base in
the current period.

Income before Income Taxes
Consolidated

As a result of the discussion above related to revenues and expenses, consolidated income before income taxes for 2004 increased

to 5.4 %, as a percentage of consolidated revenues, compared to 4.7% in 2003.

Reportable Segments

Housekeeping’s 25.6% increase in income before income taxes is attributable to the improvement in the gross proﬁt earned at the

client facility level and the gross proﬁt earned on the 12.3% increase in reportable segment revenues.

Food’s income before income taxes decreased 1.5% on a reportable segment basis. The decrease is attributable to a lower gross
proﬁt earned at the client facility level resulting primarily from the discussion above related to labor and other labor costs

increase.

Consolidated Investment and Interest Income

Investment and interest income, as a percentage of consolidated revenues, was .3% in 2004 compared to .4% in 2003. The slight

decrease is primarily attributable to a reduction in interest income earned on clients’ notes receivable as a result of having less
outstanding balances on such notes during 2004.

Consolidated Income Taxes
Our effective tax rate at both December 31, 2004 and 2003 was 38%. Our 38% effective tax rate differs from the federal income

tax statutory rate principally because of the effect of state and local income taxes.

Consolidated Net Income
As a result of the matters discussed above, consolidated net income for 2004 increased to 3.4%, as a percentage of consolidated

revenues, compared to 2.9% in 2003.

Critical Accounting Policies and Estimates

We consider the two policies discussed below to be critical to an understanding of our ﬁnancial statements because their

application places the most signiﬁcant demands on our judgment. Therefore, it should be noted that ﬁnancial reporting results
rely on estimating the effect of matters that are inherently uncertain. Speciﬁc risks for these critical accounting policies and

estimates are described in the following paragraphs. For these estimates, we caution that future events rarely develop exactly as
forecasted, and the best estimates routinely require adjustment. Any such adjustments or revisions to estimates could result in

material differences to previously reported amounts.

The two policies discussed are not intended to be a comprehensive list of all of our accounting policies. In many cases, the

accounting treatment of a particular transaction is speciﬁcally dictated by generally accepted accounting principles, with no need
for our judgment in their application. There are also areas in which our judgment in selecting another available alternative would

not produce a materially different result. See our audited consolidated ﬁnancial statements and notes thereto which are included

in this Annual Report, which contain accounting policies and other disclosures required by generally accepted accounting
principles.

Allowance for Doubtful Accounts
The Allowance for Doubtful Accounts is established as losses are estimated to have occurred through a provision for bad debts

charged to earnings. The Allowance for Doubtful Accounts is evaluated based on our periodic review of accounts and notes

receivable and is inherently subjective as it requires estimates that are susceptible to signiﬁcant revision as more information
becomes available.

We have had varying collection experience with respect to our accounts and notes receivable. When contractual terms are not

met, we generally encounter difﬁculty in collecting amounts due from certain of our clients. Therefore, we have sometimes been

required to extend the period of payment for certain clients beyond contractual terms. These clients include those who have
terminated service agreements and slow payers experiencing ﬁnancial difﬁculties. In making credit evaluations, in addition to

analyzing and anticipating, where possible, the speciﬁc cases described above, we consider the general collection risks associated
with trends in the long-term care industry. We also establish credit limits, perform ongoing credit evaluations, and monitor

accounts to minimize the risk of loss.

In accordance with the risk of extending credit, we regularly evaluate our accounts and notes receivable for impairment or loss of

value and when appropriate, will provide in our Allowance for Doubtful Accounts for such receivables. We generally follow a
policy of reserving for receivables from clients in bankruptcy, clients with which we are in litigation for collection and other slow

paying clients. The reserve is based upon our estimates of ultimate collectibility. Correspondingly, once our recovery of a
receivable is determined through either litigation, bankruptcy proceedings or negotiation to be less than the recorded amount on

our balance sheet, we will charge-off the applicable amount to the Allowance for Doubtful Accounts.

At December 31, 2005, we identiﬁed accounts totaling $2,960,000 that require an Allowance for Doubtful Accounts based on

potential impairment or loss of value. An Allowance for Doubtful Accounts totaling $2,275,000 was provided for these accounts at
December 31, 2005. Actual collections of these accounts could differ from that which we currently estimate. If our actual

collection experience is 5% less than our estimate, the related increase to our Allowance for Doubtful Accounts would decrease
net income by $21,000.

Notwithstanding our efforts to minimize credit risk exposure, our clients could be adversely affected if future industry trends, as

more fully discussed under Liquidity and Capital Resources below, and as further described in our Form 10-K ﬁled with Securities
and Exchange Commission for the year ended December 31, 2005 in Part I thereof under ‘‘Risk Factors’’, ‘‘Government

Regulation of Clients’’ and ‘‘Service Agreements/Collections’’, change in such a manner as to negatively impact the cash ﬂows of
our clients. If our clients experience a negative impact in their cash ﬂows, it would have a material adverse effect on our results of

operations and ﬁnancial condition.

Accrued Insurance Claims

We currently have a Paid Loss Retrospective Insurance Plan for general liability and workers’ compensation insurance, which
comprise approximately 36% of our liabilities at December 31, 2005. Our accounting for this plan is affected by various

uncertainties because we must make assumptions and apply judgment to estimate the ultimate cost to settle reported claims and

claims incurred but not reported as of the balance sheet date. We address these uncertainties by regularly evaluating our claims
pay-out experience, present value factor and other factors related to the nature of speciﬁc claims in arriving at the basis for our

accrued insurance claims estimate. Our evaluations are based primarily on current information derived from reviewing our claims
experience and industry trends. In the event that our claims experience and/or industry trends result in an unfavorable change, it

would have a material adverse effect on our consolidated results of operations and ﬁnancial condition. Under these plans,

predetermined loss limits are arranged with an insurance company to limit both our per-occurrence cash outlay and annual
insurance plan cost.

For workers’ compensation, we record a reserve based on the present value of future payments, including an estimate of claims
incurred but not reported, that are developed as a result of a review of our historical data and open claims. The present value of

the payout is determined by applying an 8% discount factor against the estimated value of the claims over the estimated
remaining pay-out period. Reducing the discount factor by 1% would reduce net income by approximately $76,000. Additionally,

reducing the estimated payout period by six months would result in an approximate $132,000 reduction in net income.

For general liability, we record a reserve for the estimated ultimate amounts to be paid for known claims.

Liquidity and Capital Resources

At December 31, 2005, we had cash and cash equivalents of $91,005,000 and working capital of $142,535,000 compared to

December 31, 2004 cash and cash equivalents and working capital of $74,847,000 and $125,012,000, respectively. We view our

cash and cash equivalents as our principal measure of liquidity. Our current ratio at December 31, 2005 remained the same as at
December 31, 2004 of 7.2 to 1. On an historical basis, our operations have generally produced consistent cash ﬂow and have

required limited capital resources. We believe our current and near term cash ﬂow positions will enable us to fund our continued
anticipated growth.

Operating Activities
The net cash provided by our operating activities was $24,495,000 for the year ended December 31, 2005. The principal sources of

net cash ﬂows from operating activities for 2005 were net income, including non-cash charges to operations for bad debt

provisions and depreciation. Additionally, operating activities’ cash ﬂows increased by $2,324,000 as a result of the timing of
payments for accrued payroll, accrued and withheld payroll taxes. The operating activity that used the largest amount of cash

during the year ended December 31, 2005 was a net increase of $3,895,000 in accounts and notes receivable and long-term notes
receivable resulting primarily from the 5.4% growth in the Company’s 2005 revenues.

Investing Activities
Our principal use of cash in investing activities for the year ended December 31, 2005 was $1,897,000 for the purchase of

housekeeping equipment, computer software and equipment, and laundry equipment installations. Under our current plans,

which are subject to revision upon further review, it is our intention to spend an aggregate of $2,000,000 to $3,000,000 during
2006 for such capital expenditures.

Financing Activities
During 2005, we paid to shareholders regular quarterly cash dividends in the aggregate of $8,076,000. Such regular quarterly cash

dividend payments of $.06, $.07, $.08 and $.09 per common share were paid on February 11, May 16, August 12, and
November 18, 2005, respectively. Additionally, on January 24, 2006, our Board of Directors declared a regular quarterly cash

dividend of $.10 per common share to be paid on February 13, 2006 to shareholders of record as of February 3, 2006.

Our Board of Directors reviews our dividend policy on a quarterly basis. Although there can be no assurance that we will
continue to pay dividends or the amount of the dividend, we expect to continue to pay a regular quarterly cash dividend. In

connection with the establishment of our dividend policy, we adopted a Dividend Reinvestment Plan in 2003.

During the year ended December 31, 2005, we expended $3,857,000 for the repurchase of 218,000 shares of our common stock.

We remain authorized to purchase 1,282,000 shares pursuant to previous Board of Directors’ actions.

During 2005, we received proceeds of $5,549,000 from the exercise of stock options by employees and directors.

Line of Credit
We have a $25,000,000 bank line of credit on which we may draw to meet short-term liquidity requirements in excess of

internally generated cash ﬂow. Amounts drawn under the line of credit are payable upon demand. At December 31, 2005, there

were no borrowings under the line of credit. However, at such date, we had outstanding a $17,925,000 (increased to $23,925,000
on January 1, 2006) irrevocable standby letter of credit which relates to payment obligations under our insurance programs. As a

result of the letter of credit issued, the amount available under the line of credit was reduced by $17,925,000 at December 31,
2005. The line of credit requires us to satisfy two ﬁnancial covenants. Such covenants, and their respective status at December 31,

2005, were as follows:

Covenant Description and Requirement

Status at December 31, 2005

Commitment coverage ratio: cash and cash equivalents must

Commitment coverage is 5.1

equal or exceed outstanding obligations under the line

of credit by a multiple of 2.

Tangible net worth: must exceed $112,000,000.

Tangible net worth is $146,000,000

As noted above, we complied with both ﬁnancial covenants at December 31, 2005 and expect to continue to remain in

compliance with all such ﬁnancial covenants. This line of credit expires on June 30, 2006. We believe the line of credit will be

renewed at that time.

Accounts and Notes Receivable

We expend considerable effort to collect the amounts due for our services on the terms agreed upon with our clients. Many of
our clients participate in programs funded by federal and state governmental agencies which historically have encountered delays

in making payments to its program participants. The Balance Budget Act of 1997 changed Medicare policy in a number of ways,
most notably the phasing in, effective July 1, 1998, of a Medicare Prospective Payment System for skilled nursing facilities which

signiﬁcantly changed the reimbursement procedures and the amounts of reimbursement our clients receive. Many of our clients’

revenues are highly contingent on Medicare and Medicaid reimbursement funding rates. Therefore, they have been and continue
to be adversely affected by changes in applicable laws and regulations, as well as other trends in the long-term care industry. This

has resulted in certain of our clients ﬁling for bankruptcy protection. Others may follow. These factors, in addition to delays in
payments from clients, have resulted in and could continue to result in signiﬁcant additional bad debts in the near future.

Whenever possible, when a client falls behind in making agreed-upon payments, we convert the unpaid accounts receivable to

interest bearing promissory notes. The promissory notes receivable provide a means by which to further evidence the amounts
owed and provide a deﬁnitive repayment plan and therefore may ultimately enhance our ability to collect the amounts due. At

December 31, 2005 and December 31, 2004, we had $8,514,000 and $8,942,000, net of reserves, respectively, of such promissory
notes outstanding. Additionally, we consider restructuring service agreements from full service to management-only service in the

case of certain clients experiencing ﬁnancial difﬁculties. We believe that such restructurings may provide us with a means to

maintain a relationship with the client while at the same time minimizing collection exposure.

We have had varying collection experience with respect to our accounts and notes receivable. When contractual terms are not
met, we generally encounter difﬁculty in collecting amounts due from certain of our clients. Therefore, we have sometimes been

and the general risk associated with the granting of credit terms, we have recorded bad debt provisions (in an Allowance for
Doubtful Accounts) of $1,425,000, $3,700,000 and $4,550,000 in the years ended December 31, 2005, 2004 and 2003, respectively.

These provisions represent approximately .3%, .8% and 1.2%, as a percentage of total revenues for such respective periods. In

making our credit evaluations, in addition to analyzing and anticipating, where possible, the speciﬁc cases described above, we
consider the general collection risk associated with trends in the long-term care industry. We also establish credit limits, perform

ongoing credit evaluation and monitor accounts to minimize the risk of loss. Notwithstanding our efforts to minimize credit risk
exposure, our clients could be adversely affected if future industry trends change in such a manner as to negatively impact their

cash ﬂows. If our clients experience a negative impact in their cash ﬂows, it would have a material adverse effect on our results of

operations and ﬁnancial condition.

At December 31, 2005, amounts due from our Major Client represented less than 1% of our accounts receivable balance. If such
client’s successor changes its payment terms, it would increase our accounts receivable balance and have a material adverse effect

on our cash ﬂows and cash and cash equivalents.

Insurance Programs
We have a Paid Loss Retrospective Insurance Plan for general liability and workers’ compensation insurance. Under these plans,

pre-determined loss limits are arranged with an insurance company to limit both our per occurrence cash outlay and annual

insurance plan cost.

the payout is determined by applying an 8% discount factor against the estimated value of the claims over the estimated
remaining pay-out period.

For general liability, we record a reserve for the estimated ultimate amounts to be paid for known claims.

We regularly evaluate our claims’ pay-out experience, present value factor and other factors related to the nature of speciﬁc claims

in arriving at the basis for our accrued insurance claims’ estimate. Our evaluation is based primarily on current information
derived from reviewing our claims experience and industry trends. In the event that our claims experience and/or industry trends

result in an unfavorable change, it would have an adverse effect on our results of operations and ﬁnancial condition.

Capital Expenditures

The level of capital expenditures is generally dependent on the number of new clients obtained. Such capital expenditures
primarily consist of housekeeping equipment purchases, laundry and linen equipment installations, and computer hardware and

software. Although we have no speciﬁc material commitments for capital expenditures through the end of calendar year 2006, we
estimate that for the period we will have capital expenditures of $2,000,000 to $3,000,000 in connection with housekeeping

equipment purchases and laundry and linen equipment installations in our clients’ facilities, as well as expenditures relating to

internal data processing hardware and software requirements. We believe that our cash from operations, existing cash and cash
equivalents balance and credit line will be adequate for the foreseeable future to satisfy the needs of our operations and to fund

our anticipated growth. However, should these sources not be sufﬁcient, we would, if necessary, seek to obtain necessary working
capital from such sources as long-term debt or equity ﬁnancing.

Material Off-Balance Sheet Arrangements
We have no material off-balance sheet arrangements, other than our irrevocable standby letter of credit previously discussed.

Effects of Inﬂation

Although there can be no assurance thereof, we believe that in most instances we will be able to recover increases in costs
attributable to inﬂation by passing through such cost increases to our clients.

CONSOLIDATED BALANCE SHEETS

Assets

Current Assets:

Cash and cash equivalents
Accounts and notes receivable, less allowance

for doubtful accounts of $2,275,000 in 2005 and
$1,869,000 in 2004
Inventories and supplies
Deferred income taxes
Prepaid expenses and other

Total current assets

Property and Equipment:

Laundry and linen equipment installations
Housekeeping equipment and ofﬁce furniture
Autos and trucks

Less accumulated depreciation

COSTS IN EXCESS OF FAIR VALUE OF

NET ASSETS ACQUIRED
Less accumulated amortization of $1,743,000 in 2005 and 2004

NOTES RECEIVABLE-long term portion, net of discount
DEFERRED COMPENSATION FUNDING
DEFERRED INCOME TAXES-long term portion
OTHER NONCURRENT ASSETS

TOTAL ASSETS

Liabilities and Stockholders’ Equity

Current Liabilities:

Accounts payable
Accrued payroll, accrued and withheld payroll taxes
Other accrued expenses
Income taxes payable
Accrued insurance claims

Total current liabilities

ACCRUED INSURANCE CLAIMS — long term portion
DEFERRED COMPENSATION LIABILITY
COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS’ EQUITY:

Common stock, $.01 par value, 67,500,000
shares authorized, 28,677,000 shares
issued in 2005 and 27,761,000 in 2004

Additional paid-in capital
Retained earnings
Common stock in treasury, at cost, 1,616,000
shares in 2005 and 1,488,000 shares in 2004

Total Stockholders’ Equity

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

December 31,

2005

2004

$ 91,005,000

$ 74,847,000

59,197,000
11,729,000
355,000
3,330,000

55,725,000
11,015,000
574,000
3,110,000

165,616,000

145,271,000

2,416,000
15,141,000
79,000
17,636,000
12,892,000

4,744,000

1,612,000
4,555,000
5,626,000
6,181,000
96,000

2,329,000
13,987,000
80,000
16,396,000
11,592,000

4,804,000

1,612,000
5,557,000
4,062,000
5,563,000
95,000

$188,430,000

$166,964,000

8,760,000
7,792,000
657,000
1,467,000
4,405,000
23,081,000

10,277,000
6,909,000

7,272,000
6,110,000
1,692,000
1,016,000
4,169,000
20,259,000

10,227,000
5,018,000

287,000
48,603,000
112,299,000

277,000
39,374,000
101,279,000

(13,026,000)

(9,470,000)

148,163,000
$188,430,000

131,460,000
$166,964,000

See accompanying notes

CONSOLIDATED STATEMENTS OF INCOME

Revenues
Operating costs and expenses:
Cost of services provided
Selling, general and administrative

Other income:

Investment and interest

Income before income taxes
Income taxes
Net income

Basic earnings per common share

Diluted earnings per common share

Cash dividends per common share

Basic weighted average number of
common shares outstanding

Diluted weighted average number of

common shares outstanding

Years Ended December 31,

2005

2004

2003

$466,291,000

$442,568,000

$379,718,000

406,114,000
32,576,000

3,198,000

30,799,000
11,703,000
$ 19,096,000

0.71

0.67

0.30

388,668,000
31,523,000

1,329,000

23,706,000
9,007,000
$ 14,699,000

0.56

0.53

0.17

334,609,000
29,045,000

1,451,000

17,515,000
6,655,000
$ 10,860,000

0.42

0.41

0.06

26,921,000

26,221,000

25,574,000

28,320,000

27,660,000

26,682,000

See accompanying notes

CONSOLIDATED STATEMENTS OF CASH FLOWS

Cash ﬂows from operating activities:

Net Income
Adjustments to reconcile net income

to net cash provided by operating activities:
Depreciation
Bad debt provision
Deferred income taxes beneﬁts
Tax beneﬁt of stock option transactions
Non-employee stock-based compensation expense
Unrealized gain on deferred compensation

fund investments

Changes in operating assets and liabilities:

Accounts and notes receivable
Prepaid income taxes
Inventories and supplies
Notes receivable — long term portion
Deferred compensation funding
Accounts payable and other accrued expenses
Accrued payroll, accrued and withheld payroll taxes
Accrued insurance claims
Deferred compensation liability
Income taxes payable
Prepaid expenses and other assets

Years Ended December 31,

2005

2004

2003

$19,096,000

$14,699,000

$ 10,860,000

1,872,000
1,425,000
(399,000)
3,454,000
35,000

1,873,000
3,700,000
(986,000)
1,900,000
—

1,914,000
4,550,000
(174,000)
1,039,000

—

(705,000)

(336,000)

(418,000)

(4,897,000)
—

(714,000)
1,002,000
(859,000)
453,000
2,324,000
285,000
1,892,000
452,000
(221,000)

(1,279,000)
—

(560,000)
2,347,000
(879,000)
1,553,000
(7,651,000)
2,481,000
1,521,000
837,000
215,000

Net cash provided by operating activities

24,495,000

19,435,000

Cash ﬂows from investing activities:

Disposals of ﬁxed assets
Additions to property and equipment

Net cash used in investing activities

Cash ﬂows from ﬁnancing activities:

Treasury stock transactions in beneﬁt plans
Acquisition of treasury stock
Dividends paid
Reissuance of treasury stock pursuant to Dividend

Reinvestment Plan

Proceeds from the exercise of stock options

85,000
(1,897,000)

(1,812,000)

(173,000)
(3,857,000)
(8,076,000)

32,000
5,549,000

321,000
(2,387,000)

(2,066,000)

—
(6,026,000)
(4,598,000)

11,000
3,910,000

Net cash provided by (used in) ﬁnancing activities

(6,525,000)

(6,703,000)

Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of the year

16,158,000
74,847,000

10,666,000
64,181,000

(11,141,000)
884,000
(1,792,000)
2,034,000
(954,000)
1,865,000
3,177,000
4,104,000
1,602,000
179,000
(985,000)

16,744,000

221,000
(2,309,000)

(2,088,000)

—
(164,000)
(1,489,000)

2,000
2,856,000

1,205,000

15,861,000
48,320,000

Cash and cash equivalents at end of the year

$91,005,000

$74,847,000

$ 64,181,000

Supplementary Cash Flow Information:
Issuance of 90,000, 72,000, and 56,000
shares of Common Stock in 2005,
2004 and 2003, respectively, pursuant to
Employee Stock Plans

643,000

366,000

212,000

See accompanying notes

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Balance, December 31, 2002
Net income for the year
Exercise of stock options and other

share-based compensation
Tax beneﬁt arising from stock

option transactions

Purchase of common stock for treasury

(33,000 shares)

Shares issued pursuant to Employee

Stock Plans (56,000 shares)

Cash dividends – $.06 per

common share

Shares issued pursuant to Dividend
Reinvestment Plan (134 shares)

Balance, December 31, 2003
Net income for the year
Exercise of stock options and other

share-based compensation
Tax beneﬁt arising from stock

option transactions

Purchase of common stock for treasury

(579,000 shares)

Shares issued pursuant to Employee

Stock Plans (72,000 shares)

Cash dividends – $.17 per

common share

Shares issued pursuant to Dividend
Reinvestment Plan (792 shares)

Balance, December 31, 2004
Net income for the year
Exercise of stock options and other
stock-based compensation, net of
14,000 shares tendered for payment

Tax beneﬁt arising from stock

option transactions
Purchase of treasury stock

(218,000 shares)

Shares purchased and shares sold in
employee Deferred Compensation
Plan and other beneﬁt plans
(17,000 shares)

Shares issued pursuant to Employee

Stock Plans (90,000 shares)

Cash dividends – $.30 per

common share

Shares issued pursuant to Dividend
Reinvestment Plan (2,000 shares)

Years Ended December 31, 2005, 2004 and 2003

Common Stock

Amount

Additional
Paid-in
Capital

Total
Retained
Earnings

Treasury
Stock

Stockholders’
Equity

26,129,000

$261,000

$29,531,000

$ 81,807,000
10,860,000

$ (3,717,000) $107,882,000
10,860,000

780,000

8,000

2,848,000

1,039,000

2,856,000

1,039,000

(164,000)

7,000

205,000

212,000

(1,489,000)

26,909,000

269,000

1,000
33,426,000

91,178,000
14,699,000

1,000
(3,675,000)

2,000
121,198,000
14,699,000

852,000

8,000

3,948,000

(46,000)

3,910,000

1,900,000

(6,026,000)

94,000

272,000

366,000

(4,598,000)

27,761,000

277,000

6,000
39,374,000

101,279,000
19,096,000

5,000
(9,470,000)

11,000
131,460,000
19,096,000

900,000

9,000

5,575,000

3,454,000

5,584,000

3,454,000

(3,857,000)

(173,000)

16,000

1,000

181,000

461,000

643,000

(8,076,000)

19,000
$48,603,000

$112,299,000

13,000

32,000
$(13,026,000) $148,163,000

Balance, December 31, 2005

28,677,000

$287,000

See accompanying notes.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Summary of Signiﬁcant Accounting Policies
Nature of Operations

We provide housekeeping, laundry, linen, facility maintenance and food services to the health care industry, including nursing
homes, retirement complexes, rehabilitation centers and hospitals located throughout the United States. We believe that we are

the largest provider of housekeeping and laundry services to the long-term care industry in the United States rendering such
services to approximately 1,700 facilities in 45 states as of December 31, 2005. Although we do not directly participate in any

government reimbursement programs, our clients’ reimbursements are subject to government regulation. Therefore, they are

directly affected by any legislation relating to Medicare and Medicaid reimbursement programs.

We provide our services primarily pursuant to full service agreements with our clients. In such agreements, we are responsible for

service term, cancelable by either party upon 30 to 90 days notice after the initial 90-day period.

We are organized into two reportable segments; housekeeping, laundry, linen and other services (‘‘Housekeeping’’), and food
services (‘‘Food’’).

The services provided by Housekeeping consist primarily of the cleaning, disinfecting and sanitizing of patient rooms and

assorted linen items utilized by a client facility. Food, which began operations in 1997, consists of providing for the development
of a menu that meets the patient’s dietary needs, and the purchasing and preparing of the food for delivery to the patients.

Additionally, we operate two wholly-owned subsidiaries, HCSG Supply, Inc. (‘‘Supply’’) and Huntingdon Holdings, Inc

Principles of Consolidation

The consolidated ﬁnancial statements include the accounts of Healthcare Services Group, Inc. and its wholly-owned subsidiaries,

HCSG Supply, Inc. and Huntingdon Holdings, Inc. after elimination of intercompany transactions and balances.

Cash and Cash Equivalents

Cash and cash equivalents consist of short-term, highly liquid investments with a maturity of three months or less at time of

purchase.

Inventories and Supplies

Inventories and supplies include housekeeping, linen and laundry supplies, as well as food provisions. Inventories and supplies are

stated at cost to approximate a ﬁrst-in, ﬁrst-out (FIFO) basis. Linen supplies are amortized over a 24 month period.

Property and Equipment

Property and equipment are stated at cost. Additions, renewals and improvements are capitalized, while maintenance and repair

costs are expensed when incurred. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation
are removed from the respective accounts and any resulting gain or loss is included in income. Depreciation is provided by the

straight-line method over the following estimated useful lives: laundry and linen equipment installations – 3 to 7 years;
housekeeping and ofﬁce equipment – 3 to 7 years; autos and trucks – 3 years.

Revenue Recognition

Revenues from our annual service agreements with clients are recognized as services are performed.

As a distributor of laundry equipment, we occasionally sell laundry installations to certain clients. The sales in most cases

represent the construction and installation of a turn-key operation and are for payment terms ranging from 24 to 60 months. Our

accounting policy for these sales is to recognize the gross proﬁt over the life of the payments associated with our ﬁnancing of the
transactions. During 2005, 2004 and 2003 laundry installation sales were not material.

Income Taxes

The provision for income taxes has been determined using the asset and liability approach of accounting for income taxes. Under

this approach, deferred taxes represent the future tax consequences expected to occur when the reported amounts of assets and

liabilities are recovered or paid. The provision for income taxes represents income taxes paid or payable for the current year plus
the change in deferred taxes during the year. Deferred taxes result from differences between the ﬁnancial and tax bases of the

Company’s assets and liabilities and are adjusted for changes in tax rates and tax laws when changes are enacted.

In accordance with SFAS 109, deferred tax assets should be reduced by a valuation allowance if it is more likely than not that
some portion or all of the deferred tax assets will not be realized. The future realization of our net deferred tax assets depends on

the availability of sufﬁcient future taxable income. In making this determination, we considered all available positive and negative

evidence and made certain assumptions. We considered, among other things, the overall business environment and our historical
earnings. We performed this analysis as of December 31, 2005 and determined that there was sufﬁcient positive evidence to

conclude that it is more likely than not that our deferred tax assets will be realized. We will assess the need for a deferred tax
asset valuation allowance on an ongoing basis considering factors such as those mentioned above, as well as other relevant

criteria.

Earnings per Common Share

Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average

common shares outstanding for the period. Diluted earnings per common share reﬂects the weighted-average common shares
outstanding and dilutive common shares, such as those issuable upon exercise of stock options.

Stock-Based Compensation

At December 31, 2005, we had stock based compensation plans, which are described more fully in Note 4. As permitted by SFAS

No. 123, ‘‘Accounting for Stock Based Compensation’’ (‘‘SFAS No. 123’’), we account for stock-based compensation arrangements
in accordance with provisions of Accounting Principles Board (‘‘APB’’) Opinion No. 25, ‘‘Accounting for Stock Issued to

Employees’’. Compensation expense for stock options issued to employees is based on the difference on the date of grant, between

the fair market value of our stock and the exercise price of the option. No stock based employee compensation cost is reﬂected in
net income, as all options granted under our plans had an exercise price equal to the market value of the underlying common

stock at the date of grant. We account for equity instruments issued to non-employees in accordance with the provisions of SFAS
No. 123 and Emerging Issues Task Force (‘‘EITF’’) Issue No. 96-18, ‘‘Accounting for Equity Instruments That Are Issued to Other

Than Employees for Acquiring, or in Conjunction With Selling, or in Conjunction With Selling Goods or Services’’. Accordingly,

all transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for
based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably

measurable.

The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition
provisions of SFAS No. 123 to stock based compensation.

Net Income

As reported

Deduct:

Total stock based employee compensation

expense determined under fair value based
method for all awards, net of related

tax effects

Pro forma

Basic Earnings Per Common Share

As reported

Pro forma

Diluted Earnings Per Common Share

As reported

Pro forma

Year Ended December 31,

2005

2004

2003

$19,096,000

$14,699,000

$10,860,000

(3,735,000)

(1,619,000)

(1,639,000)

$15,361,000

$13,080,000

$ 9,221,000

.71

.57

.67

.54

.56

.50

.53

.47

.42

.36

.41

.35

The fair value of the options granted as reported in the table above was estimated at the date of grant using the Black-Sholes

pricing model with the following assumptions: risk free interest rate (2.0% to 7.0%), dividend yield (.4% to 1.45%), expected
volatility (35.0% to 37.9%), and weighted average expected life (2.32 years – 5.00 years)

In December 2004, the Financial Accounting Standards Board (the ‘‘FASB’’) issued a revision of SFAS No 123 (‘‘SFAS No.

123R’’). This new statement supersedes APB Opinion No. 25 and its related implementation guidance. SFAS No. 123R requires a
public entity to measure the cost of options granted based on the grant-date fair value of the grant award (with limited

exceptions). That cost will be recognized over the vesting period of the granted options. This statement is effective as of the ﬁrst
annual reporting period that begins after June 15, 2005. We have adopted the standard on January 1, 2006. The adoption of SFAS

123R is expected to have a material impact, starting in the 2006 fourth quarter, on our consolidated results of operations and

ﬁnancial position. This impact will result from the share based payments of our 2006 Employee Stock Purchase Plan and the
stock options expected to be granted during the 2006 fourth quarter. Although such impact is expected to be material, the impact

cannot be reasonably estimated because it will depend on certain factors which are not fully known at this time. The options
outstanding at December 31, 2005 (including options granted during the 2005 fourth quarter) will not impact 2006 consolidated

results of operations and ﬁnancial position since all option-holders were fully vested in such options at December 31, 2005.

Advertising Costs

Advertising costs are expensed when incurred. For the years ended December 31, 2005, 2004 and 2003, advertising costs were not

material.

Long-Lived Assets and Impairment of Long-Lived Assets

Our long-lived assets include property and equipment and costs in excess of fair value of net assets acquired (i.e. goodwill). Costs

in excess of fair value of net assets acquired arose from the purchase of another company in 1985 which were being amortized
over a 31 year period and is included in other noncurrent assets.

As of January 1, 2002 we adopted SFAS No. 142 ‘‘Goodwill and Other Intangible Assets’’, which eliminated the amortization of
purchased goodwill. Upon adoption of SFAS No. 142, as well as at December 31, 2005 and 2004, we performed an impairment

test of our goodwill (amounting to $1,612,000 at these dates) and determined that no impairment of the recorded goodwill
existed. Under SFAS No. 142, goodwill is tested annually and more frequently if an event occurs which indicates the goodwill may

be impaired.

As of January 1, 2002, we adopted SFAS No. 144, ‘‘Accounting for the Impairment or Disposal of Long-lived Assets’’ which

supersedes SFAS No. 121, ‘‘Accounting for the Impairment of Long-lived Assets to be Disposed Of’’. The adoption of SFAS No.
144 had no effect on the Company.

Treasury Stock

Treasury stock purchases are accounted for under the cost method whereby the entire cost of the acquired stock is recorded as

treasury stock. Gains or losses on the subsequent reissuance of shares are credited or charged to additional paid in capital.

Three-for-Two Stock Splits

On April 19, 2005, our Board of Directors approved a three-for-two stock split in the form of a 50% common stock dividend
which was paid on May 2, 2005 to shareholders of record on April 29, 2005. Additionally, on February 12, 2004, our Board of

Directors approved a three-for-two stock split in the form of a 50% common stock dividend which was paid on March 1, 2004 to

shareholders of record on February 23, 2004. All share and per common share information for all periods presented have been
adjusted to reﬂect the three-for-two stock splits.

Reclassiﬁcation

Certain prior period amounts have been reclassiﬁed to conform to current year presentation.

Use of Estimates in Financial Statements

In preparing ﬁnancial statements in conformity with generally accepted accounting principles, we make estimates and assumptions

that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the
ﬁnancial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could

differ from those estimates. Signiﬁcant estimates are used for, but not limited to, our allowance for doubtful accounts, accrued

insurance claims and deferred tax beneﬁts. The estimates are based upon various factors including current and historical trends,
as well as other pertinent industry and regulatory authority information. We regularly evaluate this information to determine if it

is necessary to update the basis for our estimates and to compensate for known changes.

Concentrations of Credit Risk

SFAS No. 105, ‘‘Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments
with Concentrations of Credit Risk’’, requires the disclosure of signiﬁcant concentrations of credit risk, regardless of the degree of

such risk. Financial instruments, as deﬁned by SFAS No. 105, which potentially subject us to concentrations of credit risk, consist

principally of cash and cash equivalents and accounts and notes receivable. At December 31, 2005 and 2004, substantially all of
our cash and cash equivalents were invested with one large ﬁnancial institution located in the United States.

Our clients are concentrated in the health care industry, primarily providers of long-term care. Many of our clients’ revenues are

highly contingent on Medicare and Medicaid reimbursement funding rates, which have been and continue to be adversely affected
by the change in Medicare payments under the 1997 enactment of the Prospective Payment System. That change and lack of

substantive reimbursement funding rate reform legislation, as well as other trends in the long-term care industry have resulted in

certain of our clients ﬁling for bankruptcy protection. Others may follow. Any decisions by the government to discontinue or
adversely modify legislation related to reimbursement funding rates will have a material adverse affect on our clients. These

factors, in addition to delays in payments from clients, have resulted in, and could continue to result in, signiﬁcant additional bad
debts in the near future.

Major Client

We have one client, a nursing home chain, which due to its signiﬁcant contribution to our total revenues, we consider a major

client. Such client’s percentage contribution to revenues and accounts receivable balances is summarized below:

Total Revenues

Reportable Segments Revenues
Food
Housekeeping

Amounts due at December 31,
% of accounts receivable balance

2005

2004
2003

19%

20%
23%

18%

19%
23%

27%

27%
22%

less than 1%

less than 1%
less than 1%

According to public ﬁlings, the client entered into a merger agreement on August 16, 2005 and the transaction is expected to
close in the ﬁrst quarter of 2006. Although we expect to continue our relationship with this client’s successor, there can be no

assurance thereof, and the loss of such client would have a material adverse affect on our results of operations of our two
operating segments. Additionally, if such client’s successor changes its payment terms, it would increase our accounts receivable

balance and have a material adverse effect on our cash ﬂows and cash and cash equivalents.

Fair Value of Financial Instruments

The carrying value of ﬁnancial instruments (principally consisting of cash and cash equivalents, accounts and notes receivable and
accounts payable) approximate fair value based on their short-term nature. We estimate the fair value of our other ﬁnancial

instruments through the use of public market prices, quotes from ﬁnancial institutions and other available information.

We have certain notes receivable that do not bear interest. Therefore, such notes receivable of $3,365,000 and $3,984,000 at

December 31, 2005 and 2004, respectively, have been discounted to their present value and are reported at such values of
$2,288,000 and $2,855,000 at December 31, 2005 and 2004, respectively.

Recent Accounting Pronouncements

In December 2004, the FASB issued a revision of Financial Accounting Standards No. 123 (‘‘SFAS 123R’’) which requires all
share-based payments to employees to be recognized in the income statement based on their fair values. Our option grants to

employees, non-employees and directors, as well as common stock shares issued pursuant to our Employee Stock Purchase Plan

will represent share-based payments.

As permitted by Statement 123, we currently account for share-based payments to employees in accordance with APB No. 25. We
expect to calculate the fair value of share-based payments under SFAS 123R on a basis substantially consistent with the fair value

approach of SFAS 123. We have adopted SFAS 123R in our ﬁscal year beginning January 1, 2006. The adoption of SFAS 123R is

expected to have a material impact, starting in the 2006 fourth quarter, on our consolidated results of operations and ﬁnancial
position. This impact will result from the share based payments under our 2006 Employee Stock Purchase Plan and the stock

options expected to be granted during the 2006 fourth quarter. Although such impact is expected to be material, the impact
cannot be reasonably estimated because it will depend on certain factors which are not fully known at this time. The options

outstanding at December 31, 2005 (including options granted during the 2005 fourth quarter) will not impact 2006 consolidated

results of operations and ﬁnancial position since all option-holders were fully vested in such options at December 31, 2005.

In May 2005, the FASB issued SFAS No. 154, ‘‘Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20
and FASB Statement No. 3.’’ This statement will be effective for accounting changes and corrections of errors made in ﬁscal years

beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in ﬁscal

years beginning after the date this statement was issued. This statement requires retrospective application to prior periods’
ﬁnancial statements of changes in accounting principle, unless it is impracticable to determine either the period-speciﬁc effects or

the cumulative effect of the change. The Company does not anticipate that the adoption of this statement will have a material
impact on our consolidated results of operations or ﬁnancial condition.

Note 2—Allowance for Doubtful Accounts

The Balance Budget Act of 1997 changed Medicare policy in a number of ways, most notably the phasing in, effective July 1, 1998
of a Medicare Prospective Payment System for skilled nursing facilities which signiﬁcantly changed the manner and the amounts

of reimbursement they receive. Many of our clients’ revenues are highly contingent on Medicare and Medicaid reimbursement
funding rates. Therefore, they have been and continue to be adversely affected by changes in applicable laws and regulations, as

well as other trends in the long-term care industry. This has resulted in certain of our clients ﬁling for bankruptcy protection.
Others may follow. These factors, in addition to delays in payments from clients have resulted in, and could continue to result in,

signiﬁcant additional bad debts in the near future.

The allowance for doubtful accounts is established as losses are estimated to have occurred through a provision for bad debts

charged to earnings. The allowance for doubtful accounts is evaluated based on our periodic review of accounts and notes
receivable and is inherently subjective as it requires estimates that are susceptible to signiﬁcant revision as more information

becomes available.

We have had varying collection experience with respect to our accounts and notes receivable. When contractual terms are not

met, we generally encounter difﬁculty in collecting amounts due from certain of our clients. Therefore, we have sometimes been
required to extend the period of payment for certain clients beyond contractual terms. These clients have included those who

have terminated service agreements and slow payers experiencing ﬁnancial difﬁculties. In order to provide for these collection
problems and the general risk associated with the granting of credit terms, we have recorded bad debt provisions (in an

Allowance for Doubtful Accounts) of $1,425,000, $3,700,000 and $4,550,000 in the years ended December 31, 2005, 2004 and

2003, respectively. In making our credit evaluations, in addition to analyzing and anticipating, where possible, the speciﬁc cases
described above, we consider the general collection risks associated with trends in the long-term care industry. Notwithstanding

our efforts to minimize our credit risk exposure, our clients could be adversely affected if future industry trends change in such a
manner as to negatively impact their cash ﬂows. In the event that our clients experience such signiﬁcant impact in their cash

ﬂows, it would have a material adverse effect on our results of operations and ﬁnancial condition.

Impaired Notes Receivable

We evaluate our notes receivable for impairment quarterly and on an individual client basis. Notes receivable considered impaired

are generally attributable to clients that are either in bankruptcy, are subject to collection activity or those slow payers that are
experiencing ﬁnancial difﬁculties. In the event that a note receivable is impaired, it is accounted for in accordance with Statement

of Financial Accounting Standards (‘‘SFAS’’) No. 114 and SFAS No. 118; that is, it is valued at the present value of expected cash
ﬂows or market value of related collateral.

At December 31, 2005, 2004 and 2003, we had notes receivable aggregating $2,500,000, $2,500,000 and $3,900,000, respectively,

that are impaired. During 2005, 2004 and 2003, the average outstanding balance of impaired notes receivable was $2,500,000,

$3,200,000 and $4,800,000, respectively. No interest income was recognized in any of these years.

Summary schedules of impaired notes receivable, and the related reserve, for the years ended December 31, 2005, 2004 and 2003
are as follows:

2005

2004

2003

2005

2004

2003

Balance
Beginning
of Year

Impaired Notes Receivable

Additions

Deductions

Balance
End of
Year

$2,500,000

60,000

$2,500,000

$3,900,000

$1,600,000

$3,000,000

$2,500,000

$5,800,000

$ 100,000

$2,000,000

$3,900,000

Reserve for Impaired Notes Receivable

Balance
Beginning
of Year

Additions

Deductions

Balance
End of
Year

$ 500,000

$ 900,000

$ 100,000

$1,300,000

$1,900,000

$1,300,000

$2,700,000

$ 500,000

$2,500,000

$1,250,000

$1,850,000

$1,900,000

We follow an income recognition policy on notes receivable that does not recognize interest income until cash payments are
received. This policy was established for conservative reasons, recognizing the environment of the long-term care industry, and

not because such notes receivable are impaired. The difference between income recognition on a full accrual basis and cash basis,
for notes receivable that are not considered impaired, is not material. For impaired notes receivable, interest income is recognized

on a cost recovery basis only.

Note 3—Lease Commitments

We lease ofﬁce facilities, equipment and autos under operating leases expiring on various dates through 2010. Certain ofﬁce leases

contain renewal options. The following is a schedule, by calendar year, of future minimum lease payments under operating leases
that have remaining terms in excess of one year as of December 31, 2005.

Year

2006

2007
2008

2009
2010

Thereafter

Operating
Leases

$ 982,000

812,000
565,000

419,000
339,000

—

Total minimum lease payments

$3,117,000

Total expense for all operating leases was approximately $913,000, $973,000 and $961,000 for the years ended December 31, 2005,

2004 and 2003, respectively.

Note 4—Stockholders’ Equity

The Nominating, Compensation and Stock Option Committee of the Board of Directors is responsible for determining the

individuals who will be granted options, the number of options each individual will receive, the option price per share, and the

exercise period of each option.

We have granted incentive and non-qualiﬁed stock options primarily to employees and directors under either our 2002 Stock

Option Plan, 1995 Incentive and Non-Qualiﬁed Stock Option Plan for key employees or 1996 Non-Employee Director’s Stock
Option Plan. On April 19, 2005, our Board of Directors adopted an Amendment to the 2002 Stock Option Plan to increase the

total number of shares of our Common Stock available for issuance under such Plan from 2,363,000 to 3,863,000. Such
Amendment was approved by shareholders on May 24, 2005. On April 22, 2003, our Board of Directors adopted an Amendment

to the 2002 Stock Option Plan. Such Amendment was approved by shareholders on May 27, 2003. The Amendment increased the

total number of shares of our Common Stock available for issuance under such Plan from 1,125,000 shares to 2,363,000. On
March 28, 2002, our Board of Directors adopted the 2002 Stock Option Plan. It was approved by shareholders on May 21, 2002.

Incentive Stock Options

As of December 31, 2005, 3,084,000 shares of common stock were reserved under our incentive stock option plans, including

1,555,000 shares which are available for future grant. The incentive stock option price will not be less than the fair market value
of the common stock on the date the option is granted. No option grant will have a term in excess of ten years. Additionally,

options granted vest and become exercisable either on the date of grant or commencing six months from the option grant date.

A summary of incentive stock option activity is as follows:

2005

2004

2003

Weighted
Average
Price

Number
Of Shares

Weighted
Average
Price

Number
of Shares

Weighted
Average
Price

Number
of Shares

Beginning of period

$ 7.35

1,969,000

$ 5.26

2,206,000

$3.90

2,253,000

Granted
Cancelled

Exercised

End of period

20.71
5.42

6.93

318,000
(55,000)

(703,000)

13.65
7.52

4.86

468,000
(30,000)

(675,000)

8.29
4.39

3.67

648,000
(5,000)

(690,000)

$10.40

1,529,000

$ 7.35

1,969,000

$5.26

2,206,000

The weighted average fair value of incentive stock options granted during 2005, 2004 and 2003 was $4.99, $3.47 and $1.85,
respectively.

The following table summarizes information about incentive stock options outstanding at December 31, 2005.

Options Outstanding

Options Exercisable

Exercise Price Range

$ 2.25 – 3.75

$ 4.11 – 5.62

$ 8.29 – 8.29
$13.65 – 20.71

Number
Outstanding

267,000

338,000

269,000
655,000

1,529,000

Average
Remaining
Contractual
Life

Weighted
Average
Exercise
Price

$ 3.00

4.98

8.29
17.09

3.85

6.54

7.99
7.05

6.54

Number
Exercisable

267,000

338,000

269,000
655,000

Weighted
Average
Exercise
Price

$ 3.00

4.98

8.29
17.09

$10.40

1,529,000

$10.40

Non-Qualiﬁed Options

As of December 31, 2005, 1,481,000 shares of common stock were reserved under our non-qualiﬁed stock option plans, including

167,000 shares which are available for future grant. Pursuant to the terms of the 1996 Non-Employee Director’s Stock Option

Plan, each eligible non-employee director receives an automatic grant based on a prescribed formula on the ﬁxed annual grant
date. The non-qualiﬁed options were granted at option prices which were not less than the fair market value of the common

stock on the date the options were granted. The options are exercisable over a ﬁve to ten year period, either on the date of grant
or commencing six months from the option date.

A summary of non-qualiﬁed stock option activity is as follows.

2005

2004

2003

Weighted
Average
Price

Number
Of Shares

Weighted
Average
Price

Number
of Shares

Weighted
Average
Price

Number
of Shares

Beginning of period

$ 5.63

1,417,000

$ 4.52

1,438,000

$3.85

1,313,000

Granted
Cancelled

Exercised

End of period

20.71
—

3.67

108,000
—

(211,000)

13.65
—

3.78

157,000
—

(178,000)

8.29
—

3.63

214,000
—

(89,000)

$ 7.18

1,314,000

$ 5.63

1,417,000

$4.52

1,438,000

The weighted average fair value of non-qualiﬁed options granted during 2005, 2004 and 2003 were $7.08, $4.49 and $2.53,

respectively.

The following table summarizes information about non-qualiﬁed stock options outstanding at December 31, 2005.

Options Outstanding

Options Exercisable

Exercise Price Range

$ 2.25 – 3.75

$ 4.09 – 5.62

$8.29 – 8.29
$13.65 – 20.71

Number
Outstanding

295,000

562,000

193,000
264,000

1,314,000

Average
Remaining
Contractual
Life

Weighted
Average
Exercise
Price

$ 3.17

4.50

8.29
16.53

3.73

6.02

8.00
7.36

6.07

Number
Exercisable

295,000

562,000

193,000
264,000

Weighted
Average
Exercise
Price

$ 3.17

4.50

8.29
16.53

$ 7.18

1,314,000

$ 7.18

Fair Value Valuation Estimates

As discussed in Note 1, we apply APB Opinion 25 in measuring stock-based compensation. Accordingly, no compensation cost

has been recorded for options granted to employees or directors in the years ended December 31, 2005, 2004 and 2003. The fair

value of each option granted has been estimated on the grant date using the Black-Scholes Option Valuation Model. The
following assumptions were made in estimating fair value:

Risk-Free Interest-Rate

Weighted Average Expected Life –

Incentive Options
Non-Qualiﬁed Options

Expected Volatility
Dividend Yield

2005

7.00%

2.32 years
4.20 years

35.0%
1.45%

2004

3.00%

2.65 years
4.46 years

35.0%
1.25%

2003

2.00%

2.34 years
5.00 years

37.9%
1.6%

Dividends

We have paid regular quarterly cash dividends since the second quarter of 2003. During 2005, we paid regular quarterly cash

dividends totaling $8,076,000 as detailed below.

2005 Cash Dividend Payments

1st Quarter

2nd Quarter

3rd Quarter

4th Quarter

Cash dividend per common share

Payment date
Record date

$.06

February 11
January 28

$.07

May 16
May 4

$.08

August 12
July 29

$.09

November 14
October 31

On January 24, 2006, our Board of Directors declared a regular quarterly cash dividend of $.10 per common share, which was
paid on February 13, 2006 to shareholders of record as of February 3, 2006.

Our Board of Directors reviews our dividend policy on a quarterly basis. Although there can be no assurance that we will

continue to pay dividends or the amount of the dividend, we expect to continue to pay a regular quarterly cash dividend. In
connection with the establishment of our dividend policy, we adopted a Dividend Reinvestment Plan in 2003.

On April 19, 2005, our Board of Directors approved a three-for-two stock split in the form of a 50% common stock dividend

which was paid on May 2, 2005 to shareholders of record on April 29, 2005. Additionally, on February 12, 2004, our Board of

Directors approved a three-for-two stock split in the form of a 50% common stock dividend which was paid on March 1, 2004 to
shareholders of record on February 23, 2004. The effect of these actions was to increase common shares outstanding by 9,345,000

to 28,036,000 and 5,980,000 to 17,950,000 in 2005 and 2004, respectively. All share and per common share information for all
periods presented have been adjusted to reﬂect the three-for-two stock splits.

Note 5—lncome Taxes

The following table summarizes the provision for income taxes.

Current:

Federal

State

Deferred:

Federal

State

Year Ended December 31,

2005

2004

2003

$ 9,732,000

$7,687,000

$5,095,000

2,370,000

2,306,000

1,734,000

12,102,000

9,993,000

6,829,000

(504,000)

105,000

(814,000)

(172,000)

(99,000)

(75,000)

(399,000)

(986,000)

(174,000)

Tax Provision

$11,703,000

$9,007,000

$6,655,000

Signiﬁcant components of our federal and state deferred tax assets and liabilities are as follows:

Net current deferred assets:
Allowance for doubtful accounts

Accrued insurance c1aims- current

Expensing of housekeeping supplies
Other

Net noncurrent deferred tax assets:

Deferred compensation
Non-deductible reserves

Depreciation of property and equipment
Accrued insurance claims- noncurrent

Other

Year Ended December 31,

2005

2004

915,000

1,771,000

(2,074,000)
(257,000)

355,000

$ 2,364,000
433,000

(822,000)
4,132,000

74,000

$ 6,181,000

765,000

1,705,000

(2,013,000)
117,000

574,000

$ 1,883,000
462,000

(1,077,000)
4,183,000

112,000

$ 5,563,000

A reconciliation of the provision for income taxes and the amount computed by applying the statutory federal income tax rate to

income before income taxes is as follows:

Tax expense computed at

statutory rate

Increases (decreases) resulting

from:
State income taxes, net of

federal tax beneﬁt

Federal jobs credits

Tax exempt interest

Other, net

Year Ended December 31,

2005

2004

2003

$10,779,000

$8,297,000

$5,955,000

1,576,000
(524,000)

(243,000)

115,000

1,386,000
(641,000)

(102,000)

67,000

1,128,000
(578,000)

(73,000)

223,000

$11,703,000

$9,007,000

$6,655,000

Income taxes paid were $8,196,000, $7,256,000 and $4,728,000 during 2005, 2004 and 2003, respectively.

Note 6—Related Party Transactions

One of our directors, as well as the brother of an ofﬁcer and director (collectively ‘‘Related Parties’’), have separate ownership
interests in several different client facilities which have entered into service agreements with us. During the years ended

December 31, 2005, 2004 and 2003 the service agreements with the client facilities in which the Related Parties have ownership

interests resulted in revenues of $7,652,000, $6,608,000 and $4,265,000, respectively. At December 31, 2005 and 2004, accounts
and notes receivable from such facilities of $2,343,000 and $1,633,000, respectively, are included in the accompanying consolidated

balance sheets. During 2005, we encountered difﬁculty in collecting amounts due from facilities operated by the brother of an
ofﬁcer and director. We were issued interest bearing promissory notes in the aggregate amount of $1,200,000 for the obligations

due. At December 31, 2005, the subject accounts and notes receivable balances due from the Related Parties are within agreed
upon payment terms.

Another of our directors is a member of a law ﬁrm which was retained by us during the years ended December 31, 2005, 2004

and 2003. Fees received from us by such ﬁrm did not exceed $100,000 in any of the years ended December 31, 2005, 2004 and

2003. Additionally, such fees did not exceed, in any year, 5% of such ﬁrm’s revenues.

Note 7—Segment Information
Reportable Operating Segments

We manage and evaluate our operations in two reportable segments. The two reportable segments are Housekeeping

(housekeeping, laundry, linen and other services), and Food (food services). Although both segments serve the same client base

and share many operational similarities, they are managed separately due to distinct differences in the type of service provided, as
well as the specialized expertise required of the professional management personnel responsible for delivering the respective

segment’s services. We consider the various services provided within Housekeeping to be one reportable operating segment since
such services are rendered pursuant to a single service agreement and the delivery of such services is managed by the same

management personnel.

Differences between the reportable segments’ operating results and other disclosed data and our consolidated ﬁnancial statements

relate primarily to corporate level transactions, as well as transactions between reportable segments and our warehousing and
distribution subsidiary. The subsidiary’s transactions with reportable segments are made on a basis intended to reﬂect the fair

market value of the goods transferred. Additionally, included in the differences between the reportable segments’ operating results
and other disclosed data are amounts attributable to our investment holding company subsidiary. This subsidiary does not

transact any business with the reportable segments. Segment amounts disclosed are prior to any elimination entries made in

consolidation.

Housekeeping provides services in Canada, although essentially all of its revenues and net income, 99% in both categories, are
earned in one geographic area, the United States. Food provides services solely in the United States.

Year Ended December 31, 2005
Revenues
Income before income taxes
Depreciation
Total assets

Year Ended December 31, 2004
Revenues
Income before income taxes
Depreciation
Total assets

Year Ended December 31, 2003
Revenues
Income before income taxes
Depreciation
Total assets

Housekeeping
services

$375,133,000
31,909,000
1,229,000
62,631,000

$357,754,000
29,336,000
1,191,000
60,958,000

$318,540,000
23,361,000
1,159,000
65,045,000

Food
services

$92,864,000
2,634,000
116,000
17,754,000

$87,309,000
1,934,000
97,000
15,546,000

$62,189,000
1,964,000
69,000
14,789,000

Corporate and
eliminations

$ (1,706,000)

(3,744,000)(1)
527,000
108,045,000(2)

$ (2,495,000)

(7,564,000)(1)
585,000
90,460,000(2)

$ (1,010,000)

(7,811,000)(1)
687,000
78,494,000

(2)

Total

$466,291,000
30,799,000
1,872,000
188,430,000

$442,568,000
23,706,000
1,873,000
166,964,000

$379,718,000
17,515,000
1,915,000
158,328,000

represents primarily corporate ofﬁce cost and related overhead, as well as consolidated subsidiaries’ operating expenses that

are not allocated to the reportable segments.
represents primarily cash and cash equivalents, deferred income taxes and other current and noncurrent assets.

(1)

(2)

Total Revenues from Clients

The following revenues earned from clients differ from segment revenues reported above due to the inclusion of adjustments used

for segment reporting purposes by management. We earned total revenues from clients in the following service categories:

2005

$262,842,000

109,764,000
91,244,000

2,441,000

$466,291,000

Year Ended December 31,

2004

$249,314,000

105,545,000
85,593,000

2,116,000

$442,568,000

2003

$223,303,000

93,257,000
61,677,000

1,481,000

$379,718,000

Housekeeping services

Laundry and linen services
Food services

Maintenance services and

Other

Major Client

We have one client, a nursing home chain, which in 2005, 2004 and 2003 accounted for 19%, 20% and 23%, respectively, of total
revenues. In the year ended December 31, 2005, we derived 18% and 27%, respectively, of the Housekeeping and Food segments’

revenues from such client. Additionally, at both December 31, 2005 and 2004, amounts due from such client represented less than
1% of our accounts receivable balance. According to public ﬁlings, the client entered into a merger agreement on August 16, 2005

and the transaction is expected to close in the ﬁrst quarter of 2006. Although we expect to continue the relationship with this

client’s successor, there can be no assurance thereof, and the loss of such client would have a material adverse affect on the results
of operations of our two operating segments. In addition, if such client’s successor changes its payment terms it would increase

our accounts receivable balance and have a material adverse effect on our cash ﬂows and cash and cash equivalents.

Note 8—Earnings Per Common Share

A reconciliation of the numerators and denominators of basic and diluted earning per common share is as follows:

Net Income

Basic earnings per common share
Effect of dilutive securities:

Options

Income
(Numerator)

$19,096,000

19,096,000

Diluted earnings per common share

$19,096,000

Net Income

Basic earnings per common share

Effect of dilutive securities:

Options

Income
(Numerator)

$14,699,000

14,699,000

Diluted earnings per common share

$14,699,000

Net Income

Basic earnings per common share

Effect of dilutive securities:

Options

Income
(Numerator)

$10,860,000

10,860,000

Diluted earnings per common share

$10,860,000

Year Ended December 31, 2005

Shares
(Denominator)

Per-share
Amount

26,921,000

1,399,000

28,320,000

$.71

(.04)

$.67

Year Ended December 31, 2004

Shares
(Denominator)

Per-share
Amount

26,221,000

1,439,000

27,660,000

$.56

(.03)

$.53

Year Ended December 31, 2003

Shares
(Denominator)

Per-share
Amount

25,574,000

1,108,000

26,682,000

$.42

(.01)

$.41

No outstanding options were excluded from the computation of diluted earnings per common share for the years ended

December 31, 2005, 2004 and 2003 as none have an exercise price in excess of the average market value of our common stock

during such periods.

Note 9—0ther Contingencies

We have a $25,000,000 bank line of credit on which we may draw to meet short-term liquidity requirements in excess of

internally generated cash ﬂow. Amounts drawn under the line of credit are payable upon demand. At December 31, 2005 there
were no borrowings under the line of credit. However, at such date, we had outstanding a $17,925,000 (increased to $23,925,000

on January 1, 2006) irrevocable standby letter of credit which relates to payment obligations under our insurance programs. As a

result of the letter of credit issued, the amount available under the line of credit was reduced by $17,925,000 at December 31,
2005. The line of credit requires us to satisfy two ﬁnancial covenants. We are in compliance with the ﬁnancial covenants at

December 31, 2005 and expect to continue to remain in compliance with such ﬁnancial covenants.

We provide our services in 45 states and we are subject to numerous local taxing jurisdictions within those states. Consequently,
the taxability of our services is subject to various interpretations within these jurisdictions. In the ordinary course of business, a

jurisdiction may contest our reporting positions with respect to the application of its tax code to our services, which may result
in additional tax liabilities.

As of December 31, 2005 and December 31, 2004 we have unsettled tax assessments (including interest to date) from various state

taxing authorities of $550,000 ($358,000, net of federal income taxes) and $2,800,000 ($1,800,000, net of federal income taxes),
respectively. With respect to these assessments, we have recorded a reserve at December 31, 2005 of $155,000 ($100,000, net of

federal income taxes) and at December 31, 2004 of $900,000 ($590,000, net of federal income taxes). During 2005, we executed a
closing agreement with a state’s revenue services department settling a $2,400,000 assessment (including interest) resulting from

the state’s audit of our sales and use tax ﬁlings for the period July 1, 1999 through June 30, 2003. The closing agreement
settlement, among other understandings, required a payment of $700,000 (including interest) in connection with the audit

assessment. Such payment was charged to the aforementioned reserve.

With respect to the other remaining outstanding assessments, we intend to vigorously defend our positions that the assessments
are without merit. In other tax matters, because of the uncertainties related to both the probable outcome and amount of

probable assessment due, we are unable to make a reasonable estimate of a liability. We do not expect the resolution of any of
these matters, taken individually or in the aggregate, to have a material adverse effect on our consolidated ﬁnancial position or

results of operations.

We are involved in miscellaneous claims and litigation arising in the ordinary course of business. We believe that these matters,

taken individually or in the aggregate, would not have a material adverse affect on our ﬁnancial position or results of operations.

The Balance Budget Act of 1997 changed Medicare policy in a number of ways, most notably the phasing in, effective July 1,

1998, of a Medicare Prospective Payment System for skilled nursing facilities which signiﬁcantly changed the manner and the

amounts of reimbursement they receive. Many of our clients’ revenues are highly contingent on Medicare and Medicaid
reimbursement funding rates. Therefore, they have been and continue to be adversely affected by changes in applicable laws and

regulations, as well as other trends in the long-term care industry. This has resulted in certain of our clients ﬁling for bankruptcy
protection. Others may follow. These factors in addition to delays in payments from clients, have resulted in and could continue

to result in signiﬁcant additional bad debts in the near future.

Note 10—Accrued Insurance Claims

We currently have a Paid Loss Retrospective Insurance Plan for general liability and workers’ compensation insurance. Under

these plans, predetermined loss limits are arranged with our insurance company to limit both our per occurrence cash outlay and
annual insurance plan cost.

We regularly evaluate our claims’ pay-out experience, present value factor and other factors related to the nature of speciﬁc claims
in arriving at the basis for our accrued insurance claims’ estimate. Our evaluation is based primarily on current information

derived from reviewing our claims’ experience and industry trends. In the event that our claims’ experience and/or industry
trends result in an unfavorable change, it would have an adverse effect on our consolidated results of operations and ﬁnancial

condition.

For workers’ compensation, we record a reserve based on the present value of future payments, including an estimate of claims

incurred but not reported, that are developed as a result of a review of our historical data and open claims. The accrued

insurance claims were reduced by approximately $903,000, $935,000 and $1,287,000 at December 31, 2005, 2004 and 2003,
respectively in order to record the estimated present value at the end of each year using an 8% discount factor over the estimated

remaining pay-out period.

For general liability, we record a reserve for the estimated amounts to be paid for known claims.

Note 11—Employee Beneﬁt Plans
Employee Stock Purchase Plan

Since January 1, 2000, we have had a non-compensatory Employee Stock Purchase Plan (‘‘the ESPP’’) for all eligible employees.

All full-time and certain part-time employees who have completed two years of continuous service with us are eligible to
participate. The ESPP was implemented through four annual offerings. The ﬁrst annual offering commenced on January 1, 2000.

On February 12, 2004 (effective January 1, 2004), our Board of Directors extended the ESPP for an additional eight annual
offerings. Annual offerings commence and terminate on the respective year’s ﬁrst and last calendar day. Under the ESPP, we are

authorized to issue up to 1,800,000 shares of our common stock to our employees. Furthermore, under the terms of the ESPP,

eligible employees can choose each year to have up to $25,000 of their annual earnings withheld to purchase our Common Stock.
The purchase price of the stock is 85% of the lower of its beginning or end of the plan year market price.

The following table summarizes information about our ESPP annual offerings for the years ended December 31, 2005, 2004 and

2003:.

2005

2004

2003

ESPP Annual Offering

Common shares purchased
Per common share purchase price

64,000
$11.32

90,000
$7.17

72,000
$5.06

Common shares date of issue

January 9, 2006

January 10, 2005

January 9, 2004

Retirement Savings Plan

Since October 1, 1999, we have had a retirement savings plan for non-highly compensated employees (the ‘‘RSP’’) under Section

401(k) of the Internal Revenue Code. The RSP allows eligible employees to contribute up to ﬁfteen percent (15%) of their eligible
compensation on a pre-tax basis. There is no match by the Company.

Deferred Compensation Plan

Since January 1, 2000, we have had a Supplemental Executive Retirement Plan (the ‘‘SERP’’) for certain key executives and

employees. The SERP is not qualiﬁed under section 401 of the Internal Revenue Code. Under the SERP, participants may defer
up to 15% of their earned income on a pre-tax basis. As of the last day of each plan year, each participant will receive a 25%

match of their deferral in our Common Stock based on the then current market value. SERP participants fully vest in our

matching contribution three years from the ﬁrst day of the initial year of participation. The income deferred and our matching
contribution are unsecured and subject to the claims of our general creditors. In the aggregate, since initiation of the SERP,

148,000 shares (including the 2005 funding of shares delivered in 2006) held by the trustee are accounted for at cost, as treasury
stock. At December 31, 2005, 116,000 of such shares are vested in the respective participants’ accounts.

The following table summarizes information about our SERP for the plan years ended December 31, 2005, 2004 and 2003:

Amount expensed under SERP

Treasury shares issued to fund SERP expense

SERP trust account balance at December 31
Unrealized gains recorded in SERP trust account

SERP Plan Year

2005

2004

2003

$ 317,000

15,000

$5,626,000(1)
$ 705,000

$ 280,000

$ 238,000

20,000

29,000

$4,062,000(1)
$ 336,000

$2,848,000(1)
$ 418,000

(1) SERP trust account investments are recorded at their fair value which is based on quoted market prices.

Note 12—Selected Quarterly Financial Data (Unaudited)

2005
Revenues

Operating costs and expenses

Income before income taxes
Net income
Basic earnings per common share1
Diluted earnings per common share1
Cash dividends per common share1

2004

Revenues
Operating costs and expenses

Income before income taxes
Net income
Basic earnings per common share1
Diluted earnings per common share1
Cash dividends per common share1

March 31

June 30

September 30

December 31

Three Months Ended

$114,695,000

$108,199,000

$116,048,000

$109,494,000

$117,684,000

$110,908,000

$
$

6,876,000
4,263,000

.16
.15

.06

$
$

7,393,000
4,584,000

.17
.16

.07

$
$

7,699,000
4,774,000

.18
.17

.08

$117,864,000

$110,089,000

8,831,000
5,475,000

$
$

.20
.19

.09

$106,622,000
$101,412,000

$110,489,000
$105,101,000

$112,324,000
$106,611,000

$113,133,000
$107,067,000

$
$

5,352,000
3,318,000

.13

.12
.03

$
$

5,694,000
3,530,000

.13

.13
.04

$
$

6,006,000
3,724,000

.14

.13
.05

$
$

6,654,000
4,127,000

.16

.15
.05

Year-to-date earnings and cash dividends per common share amounts may differ from the sum of quarterly amounts due to

rounding.

MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER
FINANCIAL REPORTING

The management of Healthcare Services Group, Inc., is responsible for establishing and maintaining adequate internal control

over ﬁnancial reporting. The Company’s internal control over ﬁnancial reporting is deﬁned in Rule 13a-15(f) and 15d-15(f)
promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, the Company’s

principal executive and principal ﬁnancial ofﬁcers and effected by the Company’s board of directors, management and other

personnel, to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of The Company’s
ﬁnancial statements for external purposes in accordance with generally accepted accounting principles in the United States and

includes those policies and procedures that:

1. Pertain to the maintenance of records that in reasonable detail accurately and fairly reﬂect the transactions and

dispositions of assets of the Company;

2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁnancial statements in

accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being

made only in accordance with authorizations of management and directors of the company; and

3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of

the Company’s assets that could have a material effect on the ﬁnancial statements.

The Company’s management assessed the effectiveness of the Company’s internal control over ﬁnancial reporting as of the end of

December 31, 2005. In making this assessment, the Company’s management used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework.

Under the supervision and with the participation of our management, including our principal executive ofﬁcer and principal
ﬁnancial ofﬁcer, we conducted an evaluation of our internal control over ﬁnancial reporting, as prescribed above, for the periods

covered by this report. Based on our evaluation, our principal executive ofﬁcer and principal ﬁnancial ofﬁcer concluded that the
Company’s internal control over ﬁnancial reporting as of December 31, 2005 is effective.

Because of its inherent limitations, internal control over ﬁnancial reporting may not prevent or detect misstatements. Projections

of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of

changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

The Company’s independent auditors have attested to, and reported on, management’s evaluation of the company’s internal
control over ﬁnancial reporting as of December 31, 2005. This report appears on page 44.

Daniel P. McCartney
Chief Executive Ofﬁcer

February 14, 2006

James L. DiStefano
Chief Financial Ofﬁcer

February 14, 2006

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Stockholders and Board of Directors

Healthcare Services Group, Inc.

We have audited the accompanying consolidated balance sheets of Healthcare Services Group, Inc. and Subsidiaries as of

December 31, 2005 and 2004, and the related consolidated statements of income, cash ﬂows, and stockholders’ equity for each of
the three years in the period ended December 31, 2005. These consolidated ﬁnancial statements are the responsibility of the

Company’s management. Our responsibility is to express an opinion on these consolidated ﬁnancial statements based on our
audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated

ﬁnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the consolidated ﬁnancial statements. An audit also includes assessing the accounting principles used

and signiﬁcant estimates made by management, as well as evaluating the overall consolidated ﬁnancial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated ﬁnancial statements referred to above present fairly, in all material respects, the consolidated
ﬁnancial position of Healthcare Services Group, Inc. and Subsidiaries at December 31, 2005 and 2004 and the consolidated results

of their operations and their consolidated cash ﬂows for each of the three years in the period ended December 31, 2005, in
conformity with accounting principles generally accepted in the United States of America.

We also have audited, in accordance with the standards of the Public Company Oversight Board (United States), the effectiveness

of Healthcare Services Group, Inc’s internal control over ﬁnancial reporting as of December 31, 2005, based on criteria established

in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
and our report dated February 14, 2006 expressed an unqualiﬁed opinion thereon.

Edison, New Jersey

February 14, 2006

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Stockholders and Board of Directors

Healthcare Services Group, Inc.

We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over
Financial Reporting, that Healthcare Services Group, Inc. and Subsidiaries maintained effective internal control over ﬁnancial

reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the

Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is
responsible for maintaining effective internal control over ﬁnancial reporting and for its assessment of the effectiveness of internal

control over ﬁnancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the
effectiveness of the Company’s internal control over ﬁnancial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).

Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal

control over ﬁnancial reporting was maintained in all material respects. Our audit included obtaining an understanding of
internal control over ﬁnancial reporting, evaluating management’s assessment, testing and evaluating the design and operating

effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We
believe that our audit provides a reasonable basis for our opinion.

A Company’s internal control over ﬁnancial reporting is a process designed to provide reasonable assurance regarding the

reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with generally

accepted accounting principles. A Company’s internal control over ﬁnancial reporting includes those policies and procedures that
(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂect the transactions and dispositions

of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation
of ﬁnancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the

company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide

reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s
assets that could have a material effect on the ﬁnancial statements.

Because of its inherent limitations, internal control over ﬁnancial reporting may not prevent or detect misstatements. Also,

projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Healthcare Services Group, Inc. and Subsidiaries maintained effective internal

control over ﬁnancial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria.

Also, in our opinion, the Company maintained, in all material respects, effective internal control over ﬁnancial reporting as of
December 31, 2005, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the

consolidated balance sheets of the Company as of December 31, 2005 and 2004, and the related consolidated statements of
income, cash ﬂows, and stockholders’ equity, for each of the three years in the period ended December 31, 2005, and our report

dated February 14, 2006 expressed an unqualiﬁed opinion thereon.

Edison, New Jersey

February 14, 2006

Transfer Agent
American Stock Transfer & Trust Co.
99 Wall St.
New York, NY 10005

Auditors
Grant Thornton LLP
399 Thornall Street
Edison, NJ 08837

Directors
Daniel P. McCartney
Chairman & Chief Executive Ofﬁcer

Thomas A. Cook
President & Chief Operating Ofﬁcer

Joseph F. McCartney
Northeast Divisional Vice President

Ofﬁcers and Corporate
Management
Daniel P. McCartney
Chief Executive Ofﬁcer

Thomas A. Cook
President & Chief Operating Ofﬁcer

Frank Bennett
Food Service Divisional
Vice President

James L. DiStefano
Chief Financial Ofﬁcer & Treasurer

Michael Hammond
Western Regional Vice President

Michael Harder
Vice President - Credit Administration

Richard W. Hudson
Vice President - Finance and Secretary

Corporate Ofﬁces
Healthcare Services Group, Inc.
3220 Tillman Drive, Suite 300
Bensalem, PA 19020
215-639-4274

Corporate Counsel
Olshan Grundman Frome
Rosenzweig & Wolosky LLP
Park Avenue Tower
65 East 55th Street
New York, NY 10022

Stock Listing
Listed on the NASDAQ
National Market System Symbol - ‘‘HCSG’’

Annual Stockholders’ Meeting
Date - May 23, 2006
Time - 10:00 A.M.
Place - The Radisson Hotel of Bucks County

2400 Old Lincoln Highway
Trevose, PA 19047

Barton D. Weisman
Chairman-NuVision Management, LLC

John M. Briggs
Certiﬁed Public Accountant

Robert L. Frome, Esq.
Senior Partner - Olshan Grundman Frome

Rosenzweig & Wolosky LLP

Robert J. Moss, Esq.
President - Moss Associates

John D. Kelly
Western Divisional Vice President

Gerrod Lambrecht
Midwest Divisional Vice President

Nicholas R. Marino
Human Resources Director

Michael E. McBryan
Senior Vice President

Bryan D. McCartney
Senior Vice President

Joseph F. McCartney
Northeast Divisional Vice President

Kevin McCartney
Northeast Divisional Vice President

James Schreck
Midwest Divisional Vice President

Robert Scutta
Mid-Atlantic Divisional Vice President

David Smigel
Western Divisional Vice President

James P. O’Toole
Mid-Atlantic Divisional Vice President

Brian M. Waters
Southeast Divisional Vice President

Market Makers
As of the end of 2005, the following ﬁrms were making a market in the shares of Healthcare Services Group, Inc.:
UBS Capital Markets, L.P.
Goldman, Sachs & Co.
Jefferies & Company, Inc.
Lehman Bros. Inc.

Morgan Stanley & Co., Inc.
C.L. King & Associates
Citigroup Global Markets, Inc.
J.P. Morgan Securities

Merrill Lynch, Pierce, Fenner
Crown Financial Group
Wm. Blair & Co.

ABOUT YOUR SHARES

Healthcare Services Group, Inc.’s Common Stock is traded on the NASDAQ National Market System of the over-the-counter market. On
December 31, 2005 there were 27,062,000 of the Company’s common shares issued and outstanding. As of February 14, 2006 there were 691
holders of record of the common stock, including holders whose stock was held in nominee name by brokers or other nominees. It is estimated
that there are Xxx beneﬁcial holders.
The high and low closing price quotations for our Common Stock during the years ended December 31, 2005 and 2004, ranged as follows
(adjusted to reﬂect the 3 for 2 stock split paid in the form of a 50% common stock dividend on May 2, 2005):

1st Qtr.
2nd Qtr.
3rd Qtr.
4th Qtr.

2005 High

2005 Low

2004 High

2004 Low

$16.53
20.65
21.60
21.45

$12.54
14.17
15.77
17.01

$11.33
11.23
12.41
14.27

$ 8.44
9.86
10.13
11.69

Availability of Form 10-K
A copy of Healthcare Services Group, Inc.’s 2005 Annual Report on Form 10-K, as ﬁled with the Securities and Exchange Commission is
available on the Company’s website ‘‘www.hcsgcorp.com’’. Additionally, it will be provided without charge to each shareholder making a written
request to the Investor Relations Department of the Company at its Corporate Ofﬁces.

Healthcare Services Group, Inc. 3220 Tillman Drive Glenview Corporate Center Suite 300 Bensalem, PA 19020