Financial erosion

Concept:

Erosion in general terms means corrosion of the existing features of anything. The same goes with financial erosion which means it will result in depletion of assets, profits or anything related to a business. It can negatively impact on the company’s assets and funds. It is often considered to be a risk factor for an organization and its cash management system. There are also chances of erosion with financial assets such as options contracts or warrants that decline in value with time.

When does erosion occur?

This happens mainly with longer downward trends, those which are accelerating, whereas the short termed ones are listed as nonrecurrent losses. Usually, depreciation and natural depletion are considered to be common in terms of downward trends. Broadly this erosion can be classified into 3 types that are discussed here:

  • Profit erosion: This refers to how funds in a business get routed towards a new business. though usually, managers consider these funds as a means of investment that flows into a business, the short-term effect is usually an erosion of cash flow. The risk involved in erosion is always reflected in the company’s profit margins because the money is used in areas that may or may not be profitable in the future. Also, in some other instances of profit erosion are when sales are comparable to previous levels, cost or product production rises, the cost of materials and labor increases but sales is not more. Thus it is important to monitor the profit erosion closely.
  • Sales erosion: the steady long-term decline in overall sales will be leading to sales erosion. This doesn’t include the temporary sales declines, but these are the ones which show long-term trends. The reasons for sales erosion are the new entrants in the product market, price reduction because of competition and certain technology advancements in the product development phase.
  • Asset erosion: though there is a normal asset depreciation which occurs in due course, sometimes the asset loses value due to general depreciation and also due to technological advances in terms of new uses to the asset with added features. Such kind of losses will impact the business in a way that it will show a reduction in the book value of assets. Thus these need to closely monitor to prevent long-term

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