Erosion (in Finance)

Any negative impact that is directed towards an organization’s sales, profits, or assets

What is Erosion?

Erosion is broadly defined as any negative impact that is directed towards an organization’s sales, profits, or assets. It is a risk factor that must be taken into consideration, especially when considering the company lifecycle or the economic market cycle.

 

Erosion

 

Understanding Erosion

Erosion is not a specific term, but as mentioned before, it is broadly defined as any downward trend that occurs to a company’s operations. In order for the downward trend to be considered erosion, it must be a longer-term, persisting trend. The three types of erosion are:

 

1. Revenue Erosion

Revenue erosion occurs when there is a steady, long-term downwards trend of sales for a company. Revenue is the inflow of money that occurs from operating a business before deducting any expenses.

Revenue erosion can occur for many different reasons. Some examples are:

  • Products becoming obsolete due to new technological advancements
  • New competition taking away market share for a company
  • Current competition undercutting prices to take away market share for a company
  • Reduced overall demand for a company’s product and service

 

For sales erosion to be evident, the downwards trend should be persistent over a long timeframe and not just observed in the short term.

 

2. Profit Erosion

Profit erosion occurs when there is a steady, long-term downwards trend of income for a company.

Profit is the amount of inflows of money that is left over after deducting all expenses – such as expenses incurred to manufacture or deliver products, selling, general & administrative (SG&A) expenses, interest expenses, depreciation & amortization expenses, tax expenses, and other unusual expenses such as litigation expenses or losses on disposal of assets, etc.

Profit erosion can occur for many different reasons. Some examples are:

  • Revenue erosion (as mentioned above)
  • Investment in unprofitable projects
  • Expenses increasing over time (that are unable to be passed through to customers in terms of price increases)

 

The distinguishable factor between profit erosion and revenue erosion is that the former can be directly observed in the trend of profit margins for a company. If profit margins are decreasing over time, profit erosion is likely occurring. It means that even if revenue is stable or even increasing, profit erosion could still be occurring from increases in expenses.

Some examples of increased expenses are:

  • Increased interest expenses from a greater debt burden
  • Increased direct material costs
  • Increased direct labor costs

 

The above examples result in profit erosion if they cannot be passed through to customers via price increases. For the phenomenon to be evident, the downwards trend should be persistent over a long timeframe, and not just observed in the short term.

 

3. Asset Erosion

Asset erosion can be classified into three forms:

 

Tangible Asset Erosion

Tangible asset erosion refers to the loss of value of tangible assets over time. Tangible assets are assets that can be physically observed and touched. Examples include:

  • Machinery
  • Equipment
  • Vehicles
  • Buildings

 

Most tangible assets come with a useful life and wear out over time, and it is captured in accounting with “depreciation.” For example, a vehicle will usually have a finite useful life based on the distance driven or years being used.

Some examples of tangible asset erosion are:

 

Intangible Asset Erosion

Intangible asset erosion refers to the loss of value of intangible assets over time. Intangible assets are assets that cannot be physically observed and touched. Examples include:

  • Patents
  • Trademarks
  • Goodwill
  • Brand value

 

Some intangible assets come with a useful life – for example, patents may expire over time. It is captured in accounting with “amortization.” However, generally, intangible assets possess an indefinite life, and their value is tested for impairment periodically.

If an intangible asset is deemed to have been impaired, then its value is marked down. If markdowns of intangible assets persist over time, it is considered intangible asset erosion.

 

Financial Asset Erosion

Financial asset erosion refers to the loss of value of financial assets over time. Financial assets are instruments and securities held for financial purposes. Either speculating for a gain or hedging to protect against downside risks. Some examples of financial assets are:

  • Equity securities
  • Fixed-income securities
  • Derivatives

 

Equity securities are relatively volatile over time, so it is difficult to observe a long-term, persisting downward trend in values. It is also difficult to observe a long-term downwards trend of value in fixed-income securities as well.

Financial asset erosion is most commonly observed in options, which are derivative instruments. Options contracts come with a specified expiration date in which the option cannot be exercised past that specified date. Because of the fact, the value of the option erodes over time, eventually reaching zero at the expiration.

 

Related Readings

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Direct Cost
  • Economic Depression
  • Depreciation Methods
  • Expiration Date

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