Critical Analysis of Shariah Compliance Filters Finance Essay

The Shari'ah Compliance Filters were developed under the supervision of known Islamic scholars and Islamic Finance specialists. These filters were based the criteria for our research since they are the only known criterion for a company listed on a stock exchange to be classified as Shari'ah Compliant if all six filters are passed.

There is not much information given about how these filters were formed or what were the aspects taken under consideration in their formation. As we continued our research and studied the filters more closely, there were a lot questions raised about the background of these filters.

Here we would like to shed some light on some of the things that we believed were worth discussing and looked to be missing among the six filters.

Screening Criteria # 1: Business of the Investee Company

In order to judge the Shari'ah compliance of any counter-party, it is important to consider the nature of the business it is engaged in. When it is an investment in equity, the investor automatically becomes responsible for the way business is structured.

The Shari'ah categorizes certain commercial activities as impermissible or haram for Muslims. This impermissibility makes the investment in the shares of any company engaged in such activities as its main business, is clearly prohibited in Islam.

There are cases when a company is engaged in haram activities, and as part of the operation they have to indulge in actions which are not allowed. On the other hand, a company maybe involved in an activity that is allowed but has a subsidiary or investments in another company, which may be involved in non-Shari'ah compliant businesses.

Conventional ulema do not authorize investing in a company whose operations are haram to any extent. Whereas some other Ulema's allow investment in equities of companies which derive a minor part of their income from prohibited activities, as long as such activities are not the main area of business. So far other ulema agree to such respite only if the same can be justified on grounds of maslahah i.e. public interest. But exception is made if the activities are as invasive in the society as the evil, hard to avoid. For example serving alcoholic drinks.

Some things that need to be taken under consideration:

a) Debt availed by the company;

b) Interest and other suspect earnings of the company;

c) Extent of cash and receivables with the company.

Keeping in view the above discussion, it clarifies the aspect of what business a company does and if that business is Halal or not. Very clearly it states in the Holy Quran that alcohol is strictly prohibited, so if a company deals in a business of alcohol, it is Haram. Similarly, any company whose core business runs on interest (riba) is also Haram.

All this is well explained, but now we move on to things that have not been clarified and most of which are a common practice in our world today. Let us first look at the aspect of "bribery". Bribery has also been strictly prohibited in Islam. There are a lot of businesses that according to the 1st screening criteria are Halal, but are they still Halal if these businesses are dealing bribery? There is no answer to that in this.

Another argument is that if a brewing company makes and sells alcohol, it is creating work opportunities and contributing to the development of the society. Reminded that consumption of alcohol is prohibited, and there are religions and cultures that promote the drinking of alcohol, so if a company is producing and exporting alcohol, should it really be termed Haram? Answers to these questions are unanswered by the Ullama and these filters do not address them.

All this seems very easy, if the company's core business is according to the teachings of Islam, it is Halal, what about its operations? Shouldn't the operations of the company be also taken into account? It is agreed that it is difficult to take such aspects into consideration but then the basic purpose of these filters in our perspective is not achieved.

Screening Criteria # 2: Market price/Share > Net Liquid Assets/Share

Net Liquid Assets / Share = T.A - F.A - Inventory - CL - LTL / No. of shares outstanding

Market price of the share must be greater than the net liquid assets per share. It implies that the company should invest its excess liquid funds in its operations i.e. buy the assets for which the company acquired funds from the general public. This will decrease the ratio of net liquid assets per share. Similarly, effective operational performance will increase profitability of the company and this will be reflected in higher ROE, ROI, ROCE, and EPS etc. This will push up the demand for the company's shares and the market price of that company will eventually increase enabling the company to meet this ratio.

Comparing the market price to the net liquid assets again does not make much sense in the accounting or financial term. The market price is an external determinant where as the net liquid assets are in complete control of the company.

If a company wants to manipulate its net liquid assets, it can very easily do so, where as the market price is determined by the market as a whole. So comparing these two ratios don't make much sense in the conventional finance.

A lot factors among the net liquid assets can turn out different for different companies. Not every company uses the same accounting principles. A change in the reporting method can and does bring about a substantial difference. For example a company that uses a straight line depreciation method could have a different value then a company reporting declining method.

If a company manipulates its reporting's in such a way only to become Sharia'ah Compliant, is this considered Halal? Similarly, recording the inventory in the LIFO, FIFO or Weighted Average can change the end of year inventory. No solution to deal with this has been specified.

It is again taken into consideration that such matters are out of the reach of the researcher. The basic aim of the company is to serve its share holders and is market price to net liquid the correct way to judge that? Earnings per share can provide a good view so as to how the company is doing and how it is serving its share holder.

There is no denying these filters, these are only the questions that have not been answered by the shari'ah council and in today's world everything needs to have a logic, not everything can be relied upon blindly. There has to be solid grounds on which such criterions are to be built. This is the basic aim of this critique.

Screening Criteria # 3: Illiquid Assets/Total Assets > 0.20 or 20%

Illiquid Assets = TA - Liquid Assets (Cash, Cash equivalents, A/R, Advances, B/As etc.) Illiquid Assets are tangible assets that are not liquid. Examples include plant, machinery, inventory, building, furniture, fixtures etc. It implies that the company should invest the funds it generates from the public to invest in the tangible assets. An increase in the number of tangible assets gives the signal to the public that the company is or is planning to expand its operations and hence this sentiment can attract investors and push up the market price of the company's shares. Furthermore, this will increase the depreciation expense of the company and hence it will decrease the corporate taxes the company needs to pay to the government.

The ratio of illiquid assets to total assets should be greater than 20% is more of a way to show the public that if the ratio is more than 20%, the company is or planning on expanding, which is a good sign. But is this ratio really a criterion for the company to be doing well?

A company that owns more than 20% assets could also be going through high losses and not meeting the hopes of the investors. Also, it has also been seen as a common practice to overvalue the assets in order to show more worth. In such a case the company would looks stable and growing where as it is only trying to get the market price of its shares on a rise to attract investors.

As discussed before, such manipulations in the financial statements of a company are the responsibility of the company. If a company is not being honest about its financials, should it really be classified at Shari'ah Complainant?

The shariah advisory board must have done their homework when these filters were created, it is obligatory on them to address these problems before these filters are considered bogus.

Screening Criteria # 4: Non-Compliant Income < 5% of Gross Revenue

Non Compliant Income includes interest; income from gambling, conventional interest based derivatives, structured products and other such instruments, income from nightclubs, prostitution, casinos, tobacco, alcohol, drugs, dividend income from above mentioned businesses etc. However, Capital Gain on scrips of such businesses need not be purified.

If investments from the non-compliant businesses will be divested, it will decrease the income ratio of non-compliant income to total income. The qualitative effects of such disinvestment will be the improved image of the company in the eyes of all stakeholders especially the shareholders, creditors and the customers.

Screening Criteria # 5: Non-Shari'ah Compliant Investments < 33% of Total Assets

Non-Shari'ah Compliant Investments include investments in money market funds, money market instruments, bonds, PIBs, FIBs, CoIs, CoDs, TFCs, DSCs, conventional speculative derivatives and structured products etc.

If investments from the non-compliant businesses will be divested, it will decrease the ratio of non-compliant investments to total assets. The qualitative effects of such disinvestment will be the improved image of the company in the eyes of all stakeholders especially the shareholders, creditors and the customers.

Screening Criteria # 6: Interest Bearing Debt < 40% of Total Assets

Interest Bearing Debt includes Bonds, TFCs, Conventional Bank Loans, Finance Lease, and Preference Shares etc.

Debt financing is a double-edge sword. Leveraged companies can magnify their returns in booms, but in slumps, they lose the edge and can even go bankrupt and make both their shareholders and creditors suffer. Debt financing results in a zero-sum game in which at least one stakeholder i.e. shareholders or creditors suffer. Equity financing ensures normal returns in booms and survival in slumps. Therefore, the company will not be squeezed of liquidity as interest expense as an 'autonomous expense' will not feature as a significant portion of total operating expenses.

All the above mentioned tests are to be passed in order to be categorized as Shari'ah Compliant, if any one of the test fails the company will be taken as non-Compliant.

Cite this page