What Is Erosion?

What Is Erosion?

Let me explain erosion to you directly: it includes any negative impact on a company's associated assets or funds. You might see it affecting profits, sales, or tangible assets like manufacturing equipment. I consider erosion a general risk factor in an organization's cash management system, since the losses tend to be slow and build over time.

Erosion can also hit certain financial assets, such as options contracts or warrants that lose value as time passes—this is what we call time decay.

Understanding the Types of Erosion

Erosion most often applies to longer-term downward trends, especially those that seem to be accelerating. In my view, erosion implies a permanent change in business conditions. You shouldn't categorize short-term losses as erosion; those are listed as one-time charges or nonrecurrent losses. Standard anticipated depreciation, or the cyclical nature of certain product sales, are often just normal parts of business functions—these are more like downward trends.

Profit Erosion

Profit erosion can refer to the gradual redirection of funds from profitable segments or projects within a business to new projects and areas. Although managers almost always see money flowing into new projects as investments in long-term growth, the short-term effect is a slow erosion of cash flow. Remember, cash flow is the amount of cash that flows in and out of a company from its day-to-day operations.

The risk in profit erosion shows up in the company’s profit margins, as the monies fund areas that may or may not be profitable later. Profit margin is the percentage of sales that generates profits.

Additionally, profit erosion can occur even when sales numbers match previous levels. This happens when the cost of producing a product rises—maybe from higher materials or labor costs—but you don't raise the sales price to compensate.

Asset Erosion

Certain assets lose value over time in a process we call depreciation. Though much of this is accounted for in the business’s figures, unexpected asset erosion can still happen. These losses come from general equipment use or technological advances that make current assets less valuable or obsolete.

Asset erosion can lower the perceived value of the business overall, as it reduces the book value of the associated assets. Intangible assets like patents or trademarks, which have expiration dates, also erode in value over time, especially as that date approaches. For pharmaceutical companies, generic producers entering the market can erode their offerings and become a real concern. Amortization is the regular accounting process that reduces intangible assets' values over time.

Options contracts are derivatives, with their value based on an underlying asset. Options on stocks issued to managers or employees can erode in value over time. These contracts have expiration dates, and rights must be exercised before then. As the expiration nears, the time-value erodes through time decay. Essentially, as time passes, there's less chance to profit from the option if it's not already profitable, so the value decreases.

Employee stock options are a large balance sheet item for many big companies, making this value loss important when you analyze financial statements.

Sales Erosion

Sales erosion is the process of steady, long-term declines in overall sales numbers. These differ from temporary drops because they're widespread and may qualify as long-term trends in the business’s activities.

You can experience sales erosion from factors like new entries into the product market or price undercutting by competitors. Technological advances can also cause it if newer developments make your current offerings seem obsolete.