What is Business Erosion?
Business erosion can include any negative impact on a company’s associated assets or funds. Erosion can be experienced with regard to profits, sales, or tangible assets, such as manufacturing equipment. Erosion is often considered a general risk factor within an organization’s cash management system, as the losses may be slow and occur over time.
Erosion can also affect certain financial assets, such as options contracts or warrants, that decline in value as time passes— a phenomenon known as time decay.
Key Takeaways
- Erosion generally applies to longer-term downward trends in a company’s business; short-term losses are usually not considered erosion.
- Profit erosion can happen when profits are redirected elsewhere in a business or costs rise.
- Unexpected asset erosion, such as due to technical innovation, can lower the perceived value—or book value—of a business.
- Sales erosion happens when there are long-term declines in sales, often due to new competition or price undercutting.
Elevate Your Business by Understanding the Types of Erosion
Erosion most often applies to longer-term downward trends, especially those that seem to be accelerating. Erosion implies a permanent change in business conditions, whereas short-term losses are categorized as one-time charges or nonrecurrent losses. Standard anticipated depreciation or the cyclical nature of certain product sales are more likely referred to as downward trends rather than erosion.
Profit Erosion
Profit erosion can refer to the gradual redirection of funds from profitable segments within a business to new projects and areas. Managers often consider money flowing into new projects as investments in long-term growth, but the short-term effect may result in slow erosion of cash flow—the amount of cash that moves in and out of a company due to its day-to-day business operations.
The risk of profit erosion is usually reflected in the company’s profit margins, as funds are redirected to areas that may or may not be profitable in the future. Additionally, profit erosion can occur even when sales numbers are comparable to previous levels if the cost of production rises without a corresponding increase in product sales price.
Asset Erosion
Certain assets lose value over time—a process often called depreciation. Though much asset depreciation is accounted for, unexpected asset erosion can still occur due to general equipment use or technological advances that make the current assets less valuable or obsolete.
Asset erosion can lower the perceived value of the business by reducing the book value of the company’s assets. Intangible assets such as patents or trademarks also face erosion over time, particularly as expiration dates approach. For pharmaceutical companies, competition from generic producers can exacerbate this issue. Amortization is the regular accounting process whereby intangible assets’ values are reduced over time.
Options contracts, which are derivatives based on underlying assets, can also erode in value over time. These contracts typically have an expiration date, and as this date approaches, the time-value in those contracts decreases—a process known as time decay.
Employee stock options have become significant figures on the balance sheets of many large companies, and this form of value loss is important in financial statement analysis.
Sales Erosion
Sales erosion refers to the process of consistent, long-term declines in overall sales. Unlike temporary sales declines, sales erosion is often considered a widespread issue that might indicate a long-term trend.
Sales erosion can result from various factors, including new entries into the market, price competition, or technological advances making current products seem obsolete.
Managing the risk of business erosion requires companies to continually innovate, carefully manage assets, and stay ahead of the competition to maintain long-term profitability.
Related Terms: Depreciation, Amortization, Profit Margins, Cash Flow, Assets, One-Time Charges.
