Equity Screening in Islamic Finance
The most important aspect of Islamic Equity Funds is Shari’ah screening. We can classify the Shari’ah restrictions on the types of equities m the fund in two categories:
(a) Restrictions related to the area or the core business of the company whose equities are to be held by the fund: Any company whose business activities are basically in the non-permissibles is not suitable for an Islamic equity fund. The list is not very long and it includes financial services banking, insurance companies, gambling, liquor, port, pornography ... etc. Notice here that we are talking about the “core” of the business activities of the company. A big company whose cafeteria in the headquarters building sell beer don’t present a violation of this restriction. Border-line cases, however, can only be resolved by a Shari’ah board on a case by case basis.
(b) Restriction related to the finances of the company. This is an operational restriction. A company that is already short-listed through our first screen may still be unsuitable for an Islamic equity fund. It is important that such companies are not engaged in non-permissible financial transactions. Certainly it would be preferable if one can find companies so pure that they depend completely on their own income, and always rely on self financing. But this is hardly possible. The question becomes, then, how to set parameters that guarantee selection of companies with minimal involvement in such non-permissible financial transactions. These parameters are:
1- Debt to equity ratio: The problem with debt in the capital structure of a company, from an Islamic point of view is that it is interest based. A company indebted through Murabaha, for instance, need not have any such restriction. Borrowing on interest is not permitted, therefore it is necessary that such borrowing is limited to a tolerable level. In certain situations Shari’ah treats minute and insignificant amount of non permissibles as negligible having no effect on the permissibility. But what is the cut off-point? There are many indications in Shari’ah which points out to the "one third" as “plenty”, and that anything less than one third is “trifle”. Though such distinction came in a different context, many contemporary Shari’ah scholars thought it relevant and assumed that a debt to equity ratio of less than 1/3 is tolerable. It is extremely important to note that such. criteria will never be suitable for wine production for example. This because, as we mentioned above, hardly any company can do without some debt. Our objective here is, therefore, to measure the extent of the firms financing with debt. Debt to equity ratio represent the relationship between funds supplied by creditors (debt) and investors (equity).
2- Interest earning: Companies whose core business is production of goods and services draw their income from profits generated from sale of such goods or services. It is not likely for any such company to earn any significant percentage of income from interest. It does happen, however, that excess cash is deposited in interest-bearing account or invested in money market instruments. This amount must be identified and investors should be advised to set aside whatever such percentage constitute out of the portfolio returns on investment. The investor may then donate the same to his favorite charity. Such amounts are usually very limited.
3- Cash and Receivables: Shari’ah distinguishes between sale of real good and that of money and debt. In the latter such sale can only be done at par value. The share of any company don't actually have an existence of its own but its value comes from the undivided portion of the assets of the company it represent. Therefore, when one buys a share he is actually buying these assets. If the latter are primarily cash and receivables then the market value of the share must be equal to the face value of these assets. Any thing more (or less) may be considered usurious from Shari’ah point of view. Because such pricing is not possible in practice, a restriction is imposed to eliminate the likelihood of such thing. This could be done by, again, putting a cap on the size of such class of assets.
Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.
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