Islamic Banking
Financial screening of Islamic equity funds

Submitted to:
Mr Arsalan Ahmed

Submitted By:
Muhammad Waqas l10-4747
Haris Naeem l10-4657

Dated: April 9, 2013

Background:
While elimination of "Riba" or interest in all its forms is an important feature of the Islamic financial system, Islamic banking is much more. At the heart of Islam is a sense of cooperation, to help one another according to principles of goodness and piety (but not to cooperate in evil or malice). In essence, it aims to eliminate exploitation and to establish a just society by the application of the Shari'ah or Islamic rulings to the operations of banks and other financial institutions. To ensure compliance to the Shari'ah, Islamic banks use the services of religious boards comprised of Shari'ah scholars.
Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. Among the ethical restrictions is the prohibition on alcohol and gambling and the consumption of pork. Islamic funds would never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products. Its practitioners and clients need not be Muslim, but they must accept the ethical restrictions underscored by Islamic values.

Financial Equity ratios:
These three ration define the criteria for Islamic equity * Leverage ratio < 33% * Cash + interest bearing securities ratio < 33% * Liquidity ratio < 45%

The understanding of these ratios have been derived from the Hadith of the Holy Prophet (P.B.U.H) that was narrated by 'Amir bin Sad bin Abi Waqqas that his father said, "In the year of the last Hajj of the Prophet I became seriously ill and the Prophet used to visit me inquiring about my health. I told him, 'I am reduced to this state because of illness and I am wealthy and have no inheritors except a daughter, (In this narration the name of 'Amir bin Sad is mentioned and in fact it is a mistake; the narrator is 'Aisha bint Sad bin Abi Waqqas). Should I give two-thirds of my property in charity?' He said, 'No.' I asked, 'Half?' He said, 'No.' then he added, 'One-third, and even one-third is much. You'd better leave your inheritors wealthy rather than leaving them poor, begging others. You will get a reward for whatever you spend for Allah's sake, even for what you put in your wife's mouth.' I said, 'O Allah's Apostle! Will I be left alone after my companions have gone?' He said, 'If you are left behind, whatever good deeds you will do will up-grade you and raise you high. And perhaps you will have a long life so that some people will be benefited by you while others will be harmed by you. O Allah! Complete the emigration of my companions and do not turn them renegades.' But Allah's Apostle felt sorry for poor Sad bin Khaula as he died in Mecca." (but Sad bin Abi Waqqas lived long after the Prophet (P.B.U.H).)

Through this Hadith we can have a much better understanding of why these ratios have been specified in terms of investing in equity securities. Looking at these ratios individually as follows:

Leverage ratio:
First level of financial screens examines the leverage ratio of that company. Shariah allows investing in a company with leverage ratio, not more than one third of equity. This ruling is based on two principles. Regardless of the serious sin committed by borrowing on the basis of interest, the loan so acquired becomes his property. And a proportion less than one-third is understood in some cases to be minor.
One-third proportion may be derived from a Hadith, related by al Bukari in which Prophet of Allah (peace be upon him) said: ….then a third. And a third is greater deal. It should be stated that empathetically here that this formula is one that applies to the investors interested in companies offering shares on the international markets over which Muslims have no controls. But it should not be understood as an endorsement of the practice, by Muslim-owned business, of interest-based borrowing.

Cash plus interest bearing securities: Cash plus interest bearing securities, mostly companies deposited their surplus into interest bearing accounts at banks or used to invest in fixed income securities .obviously this income is considered Haram, but, as has been already explained , negligible amounts of such income will not be prohibited the acquisition of share in a company. But such dubious income, however must be kept minimum, according to shariah board non-operating income should not exceed 5 percent. So cash plus interest bearing securities must be less then 33%.when the %age of Haram income can be shown to have been kept minimum it implies that the company is utilizing its recourses, labors and capital for enhancing productivity and not merely relying on Haram sources. And Haram income must be calculated and purified by way of giving to charity.

Liquidity screen:
Liquidity is calculated by account receivables in relation to total asset. As business becomes increasingly globalised the volume of everyday corporate transactions have increased from million to hundreds of millions of dollars. It is difficult for a company to pay in full cash payment of large amount; so many companies generally agree to pay in installments over a period of time. Such agreements results in the selling companies maintaining accounts receivables on their balance sheet. The shariah however, only allows selling value for value. Hence, the indebted can only sell to himself and not to third party. The shariah allows investing in share of company only if company’s account receivables do not represent the majority of total asset. Thus if primary business is Halal and sale methodology for obtaining corporate revenue is through installment payments, which may be deemed incidental or subordinate if the receivables do not exceed 45 % of total asset. Then investment in such company will be permissible. But if this ratio is more than 45% then its mean that majority of company’s dealing will actually be in money, and not in goods, services and assets. This position consistent with the established and recognized Islamic juristic rule stating that what is not permitted independently may be permitted subordinately.