What is erosion?
Erosion can have a negative impact on a company’s related assets or funds. Erosion can occur with respect to tangible assets such as profits, sales, or manufacturing equipment. Erosion is often considered a common risk factor within an organization’s money management system, as losses are slow and can occur over time.
Erosion can also occur on certain financial assets that decline in value over time, such as option contracts and warrants. This is known as time decay.
- Erosion generally applies to long-term downtrends in a company’s business. Short-term losses are usually not considered erosion.
- Profit reductions can occur when profits are redirected elsewhere in the business or costs rise.
- For example, unexpected asset erosion due to innovation can reduce the perceived value or book value of a business.
- The decline in sales occurs when sales decline in the long run, probably due to new competition or falling prices.
Understand the types of erosion
Erosion is best suited to long-term downtrends, which appear to be accelerating in particular. In other words, erosion means a permanent change in business conditions. Short-term losses are not classified as erosion, but are listed as one-time costs or non-recurring losses. Standard expected depreciation, or the cyclical nature of a particular product sale, is often considered a normal part of a business function. These are more likely to be called downtrends.
Erosion of profits
Decrease in profit refers to the gradual redirection of funds from a profitable segment or project within a business to a new project or area. Managers most often see the money flowing into a new project as an investment in long-term growth, but the short-term impact is a slow decline in cash flow. Cash flow is the amount of cash that goes in and out of a company as a result of the company’s day-to-day operations.
The risks associated with lower profits are usually reflected in the company’s rate of return. This is because money is used to fund areas that may or may not be profitable in the future. The rate of return is the percentage of sales that generate a profit.
In addition, profits can decline even if sales are comparable to previous levels. This can happen if the manufacturing cost of a particular product rises. This is probably due to higher material or labor costs, but the selling price of the product has not been raised to make up for it.
Certain assets lose their value over time. A process often referred to as depreciation. Business figures include depreciation of many assets, but unexpected asset erosion can occur. These losses can be manifested by the general use of equipment and technological advances that reduce or obsolete the value of liquid assets.
Asset erosion reduces the book value of company-related assets and can reduce the perceived value of the business as a whole. Intangible assets with expiration dates, such as patents and trademarks, also decline in value over time, especially as the date approaches. For pharmaceutical companies, generic producers entering the market can lead to erosion of their products and can be a real concern. Amortization is a normal accounting process in which the value of an intangible asset decreases over time.
Option contracts are derivatives and their value is determined by the underlying asset. Stock options issued to a company manager or employee can decline in value over time. Option contracts usually have an expiration date, and the rights contained in those contracts must be exercised before they expire. As the expiration date approaches, the time values of these contracts are eroded by a process called time decay. In other words, over time, the chances of profiting from an option diminish-if it’s not yet profitable. As a result, the value of the option diminishes or erodes over time.
This form of loss of value is important in the analysis of financial statements, as employee stock options have become a large balance sheet item for many large companies.
Sales decline refers to the process by which overall sales decline steadily over the long term. These are different from temporary sales declines because these losses are often considered to be fairly widespread and can be seen as a long-term trend in business activity.
Many factors can cause a decline in sales, such as a new entry into the market for that particular product, or a drop in price on behalf of a competitor. Technological advances in this area can also lead to lower sales if new product developments make current company offerings look outdated.