Overview of 9 Common Financial Ratios in Transfer Pricing
Financial ratios are essential tools used to evaluate a company’s financial health, operational efficiency, and profitability. In transfer pricing audits, these ratios help determine whether related-party transactions comply with the arm’s length principle (ALP). Both Philippine regulations and international standards, such as the OECD Transfer Pricing Guidelines emphasise their use for benchmarking, detecting potential tax avoidance, and supporting transfer pricing adjustments when necessary.
Key points
- Gross Margin to Sales Ratio - Measures gross profit as a percentage of total sales. Common for distributors and manufacturers.
Formula: Gross Profit divided by Sales. - Gross Profit to Basic Sales – Evaluates profitability based on the unadjusted sale price. Useful in resale price method applications.
- Rate of Return of Sale (Operating Margin) – Indicates operational efficiency and profitability. Often applied in transactional net margin method (TNMM).
Formula: operating profit divided by sales. - Rate of Return of Total Costs – Shows profit generated per peso of cost. Common in cost-plus applications.
Formula: Operating profit divided by total operating costs. - Return on Assets (ROA) – Evaluates how effectively assets generate profit. Relevant for capital-intensive businesses.
Formula: Operating profit divided by operating assets. - Rate of Outcome of Capital Employed (ROCE) Ratio – Assesses profitability relative to capital investment. Useful for entities with significant fixed assets.
Formula: Operating profit divided by capital employed. - Operating Profit to Capital Ratio – Measures the return on the capital base, often used in evaluating investment-heavy operations.
Formula: Operating profit divided by total capital. - Research and Development (R&D) Costs to Sales Ratio – Reflects investment in innovation compared to sales. Commonly used for technology, pharmaceutical, and R&D centers.
Formula: R&D costs divided total sales. - Marketing Costs to Sales Ratio – Indicates the marketing intensity relative to revenue. Relevant for marketing and distribution entities.
Formula: Marketing costs divided by total sales.
Note that RMO No. 1-2019 lists a tenth ratio called the Berry Ratio (Gross Profit / Operating Costs), which is typically used for distribution or routine service providers with minimal assets and risks, without engaging in manufacturing or owning significant intangibles.
These ratios should be analysed alongside functional analysis, evaluating functions performed, assets used, and risks assumed, to ensure that profits are aligned with economic substance.
Tax professionals and compliance officers should integrate these financial ratios into their transfer pricing documentation and analysis. By doing so, they can proactively demonstrate adherence to the ALP and mitigate risks of audit adjustments. Regular benchmarking against industry comparables is key to maintaining defensible transfer pricing positions.
(Chapter II, RAMO No. 1-2019)
Staying on top of these updates helps ensure your documentation remains compliant and accurate.