REGIME PROPOSED FOR SHARIAH COMPIANT INVESTMENTS ON INDIAN STOCK EXCHANGES
Shariah securities is a Hyderabad-based stockbroking firm specializing in offering shariah-compliant investment guidance in Indian stock markets to prospective clients.
Our core competency lies in providing very proficient and personalized guidance towards achieving investment objectives in the most conservative shariah-compliant way.
We give below the rules we propose to the prospective clients to ensure that the investment of their portfolios is shariah compliant.
PART I: RULES AS PROPOSED BY TASIS
The rules for stock market investment proposed by TASIS for the Indian context are divided into five sections as follows:
- It is not permissible to enter into any transaction involving options, futures or swaps, or a derivative, whether the underlying asset is tangible and real, for instance, a commodity or share or intangible, such as an index or occurrence of a projected event.
ACCEPTABLE PROCEDURES OF DEALING AND ENTERING INTO TRANSACTIONS
The following rules define the acceptable procedures of dealing and entering into transactions on the stock exchanges by our clients
- It is not permissible to sell a security to which the seller does not hold legal title or over which he cannot exercise effective control. (short-selling of securities is not permissible
- It is not permissible for a person to sell a security that was bought by him earlier but the price of which he has neither fully paid nor is it within his financial means to fully pay it without selling off the security that was bought. ( utilizing of margin funding options as provided by the angel is not permissible)
- It is not permissible to borrow or lend shares. They may only be bought and sold for a defined price and the price paid or quantum of debt involved in the transaction established unambiguously. (borrowing and lending of shares as defined by Sebi is not permissible for our clients)
- It is not permissible to defer payment of liability by accepting to pay an additional amount in lieu therefore or to prepone payment of the same by negotiating a discount in lieu, therefore. (not permissible to pay mark to market money in order to retain the stocks purchased in whatever conditions)
- It is not permissible to trade in equity shares of a company that is in the process of liquidation.
SECTORS OF THE ECONOMY PERMISSIBLE FOR INVESTMENT
The sectors of the Indian economy in which it is not permissible to invest are as follows:
- Those sectors in which investment is impermissible per se: these include conventional (interest-based) banking, conventional (interest-based) insurance, brokerage of conventional (interest-based) financial products and provision of fund-based financial services, manufacture, distribution, and sale of potable alcoholic beverages and narcotics, processing, distribution and sale of pork and pork-related products, gambling and tobacco; and
- Those sectors in which investment is prima facie impermissible in the Indian context till specific reliable information is available to the effect that the activities undertaken by the industry as a whole or a specific company in that industry is in accordance with the shariah, as certified by the shariah compliance monitoring agency: such industries include all meat processing industries and units marketing such products, sugar manufacturing units, media broadcasting, and entertainment industries, and diversified companies; and
- Companies whose main line of business may not lie in any of the above but which my be involved in one or more of the above activities to some extent either directly or through a subsidiary.
It is permissible to invest in any company not coming within the purview of the impermissible industry categories elaborated above.
FINANCIAL PARAMETERS FOR SHARIAH COMPLIANT COMPANIES
Equity shares of companies whose nature of business is not incompliant with the shariah on the basis of the rules given in the above section, further need to meet certain minimum financial parameters, in order to qualify as acceptable for investment as shariah-compliant stocks.
The rules in this respect are:
- Their total debt (including from banks, financial institutions, public deposits, and inter-corporate deposits) should not be greater than 25% of their total assets,
- Their interest income from all sources should not exceed 3% of their total income and
- Their receivables and cash & bank balance should not be greater than 90% of their total assets.
COMPLIANCES REQUIRED TO BE ADHERED BY CLIENTS OF SHARIAH COMPLIANT PORTFOLIOS:
There are two types of compliances which managers of shariah-compliant portfolios will need to meet. They are:
- normative compliances essential for the portfolio to be compliant with the shariah; and
- administrative compliances required to assure the shariah compliance monitoring agency that the portfolio manager is adhering to the stipulated norms for selection of the equity shares and other equity-related instruments as well as the acceptable methods of dealing and entering into transactions in order that the transactions are in compliance with shariah.
The normative compliance involves determining / estimating in case of each of the scrips held under the portfolio, the quantum of interest per share, if any, earned by the companies concerned, during holding of the scrip under the portfolio. This determination / estimation have to be done at the earliest opportunity, depending on the disclosure of the relevant information by the companies concerned.
Depending on the mandate to the portfolio manager from the investor, the information regarding the quantum of interest has to be either communicated to the investor for further action at his end (to donate it away in charity) or to be acted on so as to segregate the interest quantum from the portfolio and dispose of it in accordance with the wishes or mandate of the investor, by the portfolio manager himself.
For clarity of understanding the method of determining the interest quantum for which the investor is responsible is explained below. To avoid any confusion the most general case is considered:
Assume an investment is made in ABC Co. shares of face value 20,000 on July 1, of a particular year. Also assume total paid-up capital of ABC is 20,000,000. After holding the shares for 61 days, they are sold on August 31, of the same year. The company’s accounting year is April to March and it declares its half-yearly results by October 20. The results show that it earned interest of 150,000 during the six months of April to September.
The portfolio held 20,000 / 20,000,000, i.e., 0.1% of the total capital of ABC Co.
However, the portfolio held the shares only for 61 days of 183 days, i.e., for one-third of the half-year April to September.
Hence it has to share responsibility for one-third of the interest earned during the period, i.e., for 150,000 / 3 = 50,000.
Since the portfolio’s holding is 0.1% of the total capital, it has to donate 0.1% of 50,000 or 50.
This amount has to be donated irrespective of whether the portfolio has received a dividend or not during the period of holding.
As the previous year closed in March, there is a possibility that there could have been a dividend distribution by ABC Co. during the period its share was held by the portfolio. This distribution would however be on account of the previous year and the same was already discounted (taken into account) in the price of the shares when the shares were sold by the previous holder to the portfolio. Any interest earned by ABC in the previous year was the responsibility of the previous holder.
Hence the portfolio does not need to remove any component from the dividend for the previous year but it has to give away its share of the interest earned during its holding of ABC Co. shares. As a matter of abundant caution, it is also clarified that the purging of interest income earned has to be carried out irrespective of whether the investment in a particular share resulted in a capital gain or loss.
As the estimation/determination of the interest quantum is normally possible at the time of the release of information of the income statement, the portfolio manager needs to agree a certain reasonable maximum time frame within which the action disposing of the interest quantum is implemented and/or the relevant information is communicated to the investor, as the mandate requires.
The administrative compliances are those procedures whereby the shariah compliance monitoring agency can assure itself that the investments under the portfolio are in compliance with the list of shariah-compliant shares and that the transactions related to the portfolios are all carried out in a shariah-compliant manner.
These compliances include specification of maximum reasonable time frames for exiting from scrips which were earlier on the compliant list but have been subsequently shifted to the non-compliant list as well as for reporting such compliance to the monitoring agency by the portfolio manager. Such administrative compliances also include specification of maximum intervals and minimum frequency of monitoring of the portfolios by the shariah compliance monitoring agency in a specified period.
PART II: RATIONALE BEHIND PROPOSED RULES
We give below the rationale behind the rules proposed earlier.
RULES PERTAINING TO PERMISSIBLE CATEGORIES OF INVESTMENT
The rationales for the rules defining the permissible categories of investment are as follows:
- Equity shares are permissible for investment as they are based on the principle of musharakah and do not provide any fixed advantage to any of the participants.
- Debentures, being essentially debt securities, usually offer a specified rate of interest and carry an assurance from the issuer to redeem at par at the end of the term for which they are issued. During their term they are traded at a price which depends on the relationship between the coupon rate they carry and the prevailing rate of interest for debt of similar characteristics (i.e., tenure, liquidity and creditworthiness). If they are issued, traded and redeemed at par value, then they satisfy all the characteristics of tradeable debt under the shariah and hence are permissible. (However, this is not a realistic scenario).
- A convertible debenture (CD) is a debenture, which comes with the promise from the issuer of either a part or the entire amount of the CD to be converted into equity shares at a specified price at a specified date in the future. Before the conversion date the CD is completely a debt security and may or may not (mostly it does) carry interest. If the CD is fully convertible, (a FCD), then on conversion the original CD stands extinguished. On the other hand, in case of a partly convertible debenture (a PCD), the unconverted portion continues as a non-convertible debenture (NCD), a pure debt instrument, till it is redeemed on the specified redemption date.
- Mostly, though not necessarily, CDs are offered as a rights issue, i.e., only to existing share holders in a fixed proportion to the number of equity shares held. Thus such rights CDs are in a way a benefit meant for the existing shareholders, a benefit arising out of the ownership of the equity shares. The benefit is in the pricing of the CDs, as the CDs entitle the holder to equity shares at less than the prevailing market price of the share. They also enable the company to save on tax, while helping raise funds for new projects without diluting the stake of the existing shareholders. They can be particularly beneficial for companies with shares of which command a high price on the stock market.
Consider the following example:
XYZ Company has an existing paid-up capital of 50 million. Its existing profit after tax (PAT) is 25 million, i.e., earnings per share of 5 and a dividend per share of 2 (i.e. 20%).
The face value of its share is 10, its book value 25, and its market value 100 .
It has a debt of 100 million on which it is paying an average interest rate of 15%. Its effective tax rate is 33%.
XYZ needs an additional 100 million to set up a project which will generate additional profits.
The company can raise the additional 100 million in 3 ways:
- raise additional equity, or
- raise additional debt, or
- offer CDs as rights to the existing shareholders.
If it offers an additional 2 million equity shares at a price of 50, it will raise 100 million and the additional offer will be absorbed too. If it increases its equity, however, the market price of its shares will fall.
In the above example, as the number of shares is increased from 5 million (i.e., 50 million / 10) to 7 million, the market price will fall from 100 to about 70, as its earnings per share will come down from 5 to about 3.5. There is also a distinct possibility that it will reduce the dividend. Even if it
does not do so, the shareholders will only earn an additional 4 on every additional100 they have invested.
Alternatively, if it raises additional debt of 100 million, its overall debt will double and so also probably its interest burden, till the project goes on stream and starts contributing to the profits. As a result the net profit after tax will reduce by 40% and so correspondingly will the market price of the shares.
Instead, assume it offers 1 CD of 100 for every 5 shares held, in other words, 1 million CDs for holders of the 5 million shares. Also assume that the CDs carry 6% interest and each of them is convertible after 2 years, into 2 equity shares at a price of 50 each.
The result will be that immediately there will be no increase in the equity. The interest burden will rise by only 6 million (and in fact, the average interest rate will reduce to 10.5% from 15%). As a result, the net profit will reduce by about 4 million only or about 16% only. Even if the share price correspondingly drops by 16%, the existing shareholders will be happy as there will be no reduction in their proportionate stakes. Moreover, in the interim for each CD held, while foregoing a small interest income of 8 over 2 years (i.e., 2*[10-6]), due to lower than the market rate of interest (of say 10%), on conversion they stand to gain 68 (2*[84-50]) more, a net gain of 60 per CD or 12 per share of 10.
5. Generally, it is possible for a shareholder to renounce his entitlement to the rights (whether shares or CDs) offered, for a price. Since such a course of action does not involve either receiving interest or buying or selling debt at other than par value and further, is required to protect his equity interest, (he could use the proceeds of the sale of his entitlement to buy additional shares from the market and maintain his proportionate holding in the company which would otherwise suffer) it could be permissible.
6. Sometimes this is not possible. In such an event if a shariah-compliant shareholder does not take up the CD offered in the rights issue, he will lose out because he would have otherwise obtained additional shares at a much lower price than the market price and his proportionate holding would have been maintained (not subscribing to the issue will reduce his proportionate holding). But holding the CD would involve his earning interest. To at least reduce some of his loss he can subscribe to the CD and immediately sell it (without earning any interest). However, this will mean selling the CD at a higher than the par value. It may be noted that at this stage the CD is a debt instrument, but it is not just plain debt security – it carries with it an entitlement to equity shares at a reduced rate after some time. Under the circumstances, the shareholder’s resort to the course of action suggested could be permissible.
7. Sometimes, the CD offered is fully convertible (a FCD) and it is zero-rated, i.e. it does not carry any interest during the interim period. In such a case, if the investor subscribes to it, he must hold it till conversion. This is because the holder will not earn any interest by holding it whereas in the process of selling he will be selling debt security at higher than the par value. As in this situation, there is available to him an option whereby he can safeguard his financial interest without getting involved in selling debt security at other than par value, it would be impermissible for him to sell the CD at a higher value.
8. To recap the earlier points i. to vii. above, in the event CDs are offered on a rights basis to existing equity shareholders, they have the following options:
- Ignore the offer and let it lapse. In this event the shareholder will lose whatever benefit he could derive from the offer on account of his being a shareholder. In course of time, once the CDs are converted his proportionate interest in the company too will be reduced.
- Renounce the rights entitlement in favour of someone else for a price. The application for the CD and the investment will then be made by the person in whose favour the rights is renounced. In this case the shareholder will get part of the benefit in the form of proceeds of renouncement of his rights. With these he could buy some extra shares of the company from the market and at least partly protect his proportionate interest in the company.
- Apply for the CDs and sell them on allotment, without earning any interest. In this case he will get a better benefit than in case b. above.
- Apply for the CDs and hold them till conversion into equity shares. In this case his interest is fully protected.
RULES REGARDING ACCEPTABLE PROCEDURES OF DEALING AND ENTERING INTO TRANSACTIONS
- The rationales for most of the rules given in the relevant section in this regard are quite obvious. So in this section, we have discussed only those where there could be a possibility of difference of views. The relevant issues are:
An equity share or an equity based security has a fluctuating price, and one which can vary widely. As the use of a share is only as either an investment instrument or in the value it can realize, borrowing a share can only be either to use it to enable squaring off an existing outstanding investment transaction or to use it by realizing its value. In either case, it is used to realize a definite store of value, defined at the point of use of the share.
Borrowing a share thus boils down to borrowing a sum of money. However at the time of settling the debt (involving the share) the market value of the share can be very different. Thus at the time of settling the debt, there will almost always be either a discounting or compounding of the original debt, thus involving riba in the transaction.
This transaction also suffers from the defect of gharar for the borrower of the share is unaware of the liability he is incurring when borrowing the share.
- It is common practice in many markets for traders to take up trading positions worth several times the amount of money at their disposal. This is done by making a part payment, of say 10%, of the actual value of the transaction.
During the day, if the trader gets a favorable price he squares off the transaction and walks away with a profit. Alternatively, if he despairs of the tide turning in his favor and does not want to risk further he may square off the transaction with a loss.
This is akin to gambling. The trader has put up a stake and is just taking a chance. Then, by putting up a fraction of the amount of his effective liability, he is multiplying the chances and the risks. To restrict the element of gambling in the transaction it is essential that he is not allowed at any time to transact a total liability beyond the resources at his command, irrespective of whether he has actually paid for his purchases or not. This can be done by making it impermissible for him to sell a security, the price of which he has neither paid fully nor is in a position to do so.
- In most cases when a company is in the process of liquidation, due to large losses, the value of its assets is very less or negative and most of this is comprised of receivables, doubtful of recovery. As loans cannot be discounted, it is not permitted to trade in shares of such companies.
RULES REGARDING SECTORS OF THE ECONOMY PERMISSIBLE FOR INVESTMENT
There is general consensus about the sectors of the economy in which it is impermissible for Muslims to invest. All those sectors which involve activities prohibited by the shariah are automatically also prohibited for investment. However there are some activities in India in which investment is impermissible due to the prevailing circumstances. Thus the meat processing industry generally involves meat of animals which are not slaughtered in a halal manner.
Similarly, the sugar industry in India, by and large, uses the molasses obtained as a by-product in the manufacture of sugar, as the raw material for the manufacture of potable alcohol.
The electronic media, i.e., TV, radio and cinema, except the news channels, quite often air / exhibit content incorporating / glamourising / promoting nudity, violence, idol worship, promiscuity and such other objectionable values.
Due to the above reasons, in the Indian situation it is considered advisable to exclude the above industries from the list of industries permitted for investment.
As of now complete data on companies generally classified as “diversified” is difficult to come by. Hence for the moment such companies are also proposed to be excluded from the list of shariah compliant industries. As the data is obtained, on a detailed scrutiny of all the different activities in which individual companies from this grouping are involved, specific companies from this category will be considered for inclusion in the shariah compliant list on a case-to-case basis.
RULES REGARDING FINANCIAL PARAMETERS FOR SHARIAH COMPLIANT COMPANIES
In respect of the rules regarding financial parameters for shariah compliant companies, we have been guided on the one hand by the maqasid al shariah by and on the other by certain empirical studies carried out on the Indian stock market in the context of shariah compliant stocks. We have also kept in mind the practical aspect of availability of data for assessing the suitability of the companies.
Selection of Parameters and Ratios
We have selected four parameters and devised two ratios from them for assessing Indian companies for shariah compliance from the financial angle. The parameters selected are:
- Total Assets,
- Interest Income,
- Total Income, and
- Receivables + Cash & Bank balance
The ratios are:
- Debt: Total Assets,
- Interest Income: Total Income, and
- Receivables + Cash & Bank balance : Total Assets
We are aware that various institutions and Shariah scholars have formulated other ratios as well. We give our rationale for using the above parameters and ratios in the Indian context.
Many organizations, particularly those involved with tracking various indices, offering rating services, etc., prefer to use market capitalization as the base for comparison, i.e., as a denominator for various ratios.
We do not think Market Capitalization is a suitable base for any ratio. As the purpose for using the ratios is assessment of shariah compliance of companies, the parameters in the ratios have to be related to the capital structure and business of the company, what the companies themselves do, and not what the mass of investors think about the company. Hence the Total Assets of the company and what proportion of the Total Assets of the company is financed by Debt is what is pertinent to assessing shariah compliance.
Market Capitalization may give the total worth of the company in the market place under certain circumstances. But it is a reflection of investor sentiment about the company, not the extent of shariah compliance by the company. Secondly, Market Capitalisation keeps changing with shifting investor perceptions. These are themselves a result of a host of subjective and objective factors such as investment, fiscal and monetary policies of the government, climatic factors, political changes, weather forecasts, international political and military developments, rumors, etc. So, is shariah compliance to be a hostage to all such extraneous factors.
Finally, if Market Capitalization is used as the base, then a company may end up turning from shariah-compliant to shariah non-compliant or vice versa without any action on its part at all, just because of a change in market sentiment. Surely this flies in the face of all notions of accountability. Hence we do not think Market Capitalization is a suitable base to assess compliance on any aspect, not just the level of Debt.
Cash + Investment in Interest-bearing Investments v/s Interest Income
(Do we have to make the changes, as for the third ratio we use Cash component??)
The ratio of Cash + Investment in Interest-bearing Investments to either Market Capitalization or total Assets is another ratio used to determine shariah compliance by many organizations. Some of these do not employ any other screen to enforce a cap on interest earning, which is essential in ensuring compliance with shariah. This omission appears to imply that use of this particular ratio is in order to limit interest income by constraining the investment itself which gives rise to the interest income.
Inclusion of Cash in the parameter would tend to suggest that an alternative objective appears to be to use the ratio as a means to limit liquid assets. Interest based investments as well as cash are monetary assets and should only be traded at par. Hence there may be a desire to restrict their proportion on the company’s balance sheet to ensure Shariah compliance.
With regard to the second objective mentioned, as in the case of “Receivables”, in the case of publicly traded companies, there are some serious objections to the use of the parameter for ensuring shariah compliance. These are discussed below under the section dealing with “Receivables”. As for using this ratio for limiting Interest Income (at source), it is unexceptionable, except that it should not include “Cash” as that dilutes the focus. (its contradicting with the third ratio-Receivables + cash : Total asset)
Coming to the Indian context, we find that from the information in the public domain, we do not have a breakdown of “Investments” in a manner which can allow one to segregate “Interest-bearing Investments” from the non–interest bearing investments. The detailed break-up is more in the nature of destination of investment (such as, investment in group companies, investment in mutual funds, investment in public sector units, etc.) than from the point of view of type of income generated.
(Investment schedule is available for the companies which will give details of the interest bearing investments, but it is bit tedious task, may take more time. )
Hence it is not possible for us in any case to use a screen based on “Cash + Interest-bearing Investments”. Instead we have used a ratio based on the parameter “Interest Income”, linking it to the obvious parameter “Total Income”. In fact the ratio “Interest Income: Total Income” is also used by some organizations to put a cap on the interest earned. Some organizations use both ratios. (This paragraph can be deleted as we are using the third ratio-Receivables+ cash to total asset)
Receivables + Cash balance
Most organizations have so far been using a ratio incorporating the parameter, “Receivables”. As in case of the parameter, “Cash + Interest-bearing Investments”, the use of “Receivables” in the screening ratios appears to be borne out of a desire to limit monetary assets (which should only be exchanged at par), out of a bundle of assets - represented by a company share - which is freely traded. While there may be some justification for adopting such an approach to the valuation of small businesses run as proprietorships or partnerships, and in some cases, even closely held private companies, it is completely misplaced in the case of publicly-traded companies listed on the stock exchanges. (As we are taking the cash component the above paragraph may need corrections)
To begin with, the assets and strengths of a company are not just limited to those represented by the entries on its balance sheet. Often, the intangibles that the company possesses or has access to, such as brands, distribution, and logistics networks, patents, technical know-how, organizational strengths, key locations or personnel, the management team, organizational culture, software and design abilities, influence in decision-making circles, licenses, etc. confer more value on the company than its tangible physical assets or its cash and receivables. Thus rarely, if ever, do investors consider the extent or proportion of cash and receivables on a company’s balance sheet before deciding to buy a share for a certain price on the exchanges.
In fact, share prices on the exchanges are driven mainly by expectations of future prospects of the company, rather than the (past) historical position (only partially) reflected on its accounts statements. Hence, in the normal course, when an investor buys a share he does not even remotely consider that a part of the price he is paying is towards buying over his share of the company’s cash and receivables. Hence, there is no strong justification for limiting the proportion of Receivables (as also that of cash) on a company’s balance sheet.
At the same time, as of now most shariah authorities do require some limitation to be placed on receivables. There is however little unanimity on the level to which it needs to be restricted. In view of this we have adopted the norm in this regard set by the shariah authority of Dubai Financial Markets (DFM). The limit used by DFM is 90%. So this is the ratio TASIS too uses for receivables and cash balance.
Basis for Using Financial Ratios
The prohibition of interest in Islam is clear and unambiguous. There is therefore no leeway for permitting interest transactions under shariah, whether for earning interest or paying it, i.e., for availing an interest-bearing loan. In principle, therefore, shariah compliance implies eschewing all interest-based transactions. On the other hand in the current situation in India, interest is rampant in all walks of life and there is a paucity of shariah-compliant investment opportunities, particularly for individual investors.
In this scenario, investment in equity shares on the stock exchanges is a major investment avenue, which is per se acceptable under shariah. A difficulty arises due to the interest-based debt which companies usually resort to and the interest that they may earn in the course of business. Similar situations obtain in most Muslim countries. To mitigate the difficulties faced by the investors, various shariah scholars have permitted investment in shares of companies involved in businesses that are not repugnant to shariah, provided the interest-based dealings of those companies are within certain maximum specified limits.
These limits represent a temporary concession to prevailing circumstances and are meant to provide a measure of relief from the hardship faced by Muslim investors. Hence, although the companies qualifying under these norms are categorized as shariah-compliant, the limits are more in the nature of tolerance limits rather than ones that define compliance; compliance would really require zero interest dealings.
Defining Maximum Limits for Financial Ratios
Again, different organizations use different maximum limits for the ratios used to define shariah compliance (shariah tolerance). There are those shariah scholars who do not approve of investment in equity shares at all as they are opposed to any concession (tolerance) for interest based transactions. Those who do accept the argument of mitigating hardship however are unable to convincingly adduce a direct and specific textual guidance from the fiqh as to where the line is to be drawn and how the relevant limits are to be set.
It appears that in this regard one needs to be guided by what constitutes hardship. The best solution for this is to look for an empirical definition of “hardship” for a given environment. If the results are consistent over different environments, then possibly global norms too can be formulated to define the maximum limits for the ratios.
On this premise, two empirical studies were conducted on the companies listed on the Indian stock exchanges. The first study was run year-wise on the 500 companies listed on the Bombay Stock Exchange included in the bellwether index of Indian stock markets the BSE Sensex over the 5-year period 1st April 2000 to 31st March 2005. The next, a more exhaustive study used the total population (of over 5,000 companies) of all the companies listed on the three leading Indian stock exchanges:
- Bombay Stock Exchange (BSE)
- National Stock Exchange (NSE)
- Calcutta Stock Exchange (CSE)
The study was based on the year-wise data of the sample considered over the 5-year period 1st April 2002 to 31st March 2007. After excluding companies for which the available data was not complete, an average of about 3,400 companies remained. Of these, an average of about 2,700 companies, or 79.5% of the total, qualified as shariah-compliant on the basis of nature of business. The results in respect of all the three ratios, Debt: Total Assets, Interest Income: Total Income and Receivables + Cash: Total Asset, were very interesting and broadly in line with the results of the more limited earlier study (on the basis of which a paper was presented at the Harvard Law School Forum in 2006).
Limit for Debt Ratio
The ratio of an aggregate of Debt to an aggregate of Total Assets for the companies which were shariah compliant on nature of business, varied from a low of 26.1% to a high 29.4% over the 5 years, with a mean of 27.3%. With a maximum limit of 33% for the ratio, an average of 1,473 or 54.3% of the 2,700 companies qualified as shariah-compliant. If the allowable maximum limit was reduced to 25%, still between 990 and 1298 or a mean of 1144 companies or 42.6% of the companies qualified in different years.
Most organizations set the maximum limit for the Debt ratio at 33%. The above study shows that such a high limit is much too liberal, at least for India. As we noted earlier, the limits set for these ratios are meant to ease hardship. If in an environment like India, where there is no consciousness of operating on a shariah compliant basis, the aggregate Debt ratio is by default consistently between 26% and 30% over a period of 5 years, then there appears to be no justification for setting the ratio at 33%. Further, even with a ratio of 25%, we find that an average of 1144 companies qualify. This number is sufficiently large to afford individual investors a reasonable choice to build a viable portfolio of shares out of just the shariah compliant ones (qualifying on the basis of a limit of 25% for the Debt ratio).
Limit for Interest Ratio
The ratio of aggregate of Interest Income to aggregate of Total Income for the companies which were shariah compliant on nature of business, varied from a low of 0.74% to a high 0.86% over the 5 years, with a mean of 0.81%. With a maximum limit of 5% for the ratio, an average of 2,571 or 95.5% of the 2,700 companies qualified as shariah compliant. If the allowable maximum limit was reduced to 3%, still between 2141 and 2371 or a mean of2266 companies or 85.1% of the companies qualified in different years.
Most organizations set the maximum limit for the Interest Income ratio at 5%. As in case of the Debt ratio so also for the Interest Income ratio (in fact more so in case of the Interest Income ratio), the above study shows that the conventional limit is much too liberal, at least for India. On the same logic as given earlier about the ratios having to be set at a level to only ease hardship there appears to be no justification for setting the ratio at 5%. Further, even with a ratio of 2%, we find that an average of 2266 companies or almost 85.1% of the total companies qualify.
One may even question the reason to set the limit at 2%, when the aggregate ratio works out to less than 1%. However, there is a possibility that the extremely low value for the aggregate may be a result of either skewing of the results by some large highly profitable zero debt companies or a reflection of the profitable phase that the Indian corporate sector has recently been passing through. It is advisable to proceed cautiously rather than precipitately. At the level of 3% the limit is already quite low; in fact 60% lower than the minimum level (5%) that has been accepted so far. Even the earlier study presented at Harvard had argued for a limit of 3%, though the results of that study too were broadly similar to those of the present one.
The Indian economy is likely to grow at a relatively lower rate in the current year and the stock markets are going through a correction phase. In case actual selection and maintenance of portfolios with the proposed 2% limit is possible without problems, a further lowering of the limit could be considered at the time of the next annual review.
Limit for Receivables and Cash Ratio
The ratio of aggregate of Receivables + Cash to aggregate of Total Assets for the companies which were Shariah compliant on nature of business, varied from a low of 22.8% to a high 25% over the 5 years, with a mean of 24%. If the allowable maximum limit was kept at 90%, between 2356 and 3006 or a mean of 2656 companies or 99% of the companies qualified in different years.
Combination of Debt, Interest Income and Receivables + Cash Ratios
Finally, we can assess the effect of using a combination of all the three ratios on the aspect of easing hardship and providing a reasonable choice to investors to build a viable portfolio while still allowing only the minimum deviation from shariah principles.
Simultaneously setting the maximum limit for shariah compliance for the Debt ratio at 25%, Interest Income ratio at 3%, and that for Receivables + Cash ratio at 90%, we find that in different years between 838 and 966 companies qualify as shariah-compliant. These numbers account for between 29.1% and 37.1% of the total number of companies qualifying as shariah-compliant on the basis of nature of business and are quite sufficient for investors to build viable portfolios on a shariah-compliant basis.
If the limit for the Interest Income ratio is further reduced to 1%, the choice for investors could further reduce by upto 15% and the available stocks for selection could further come down to as low as only 571 stocks.
Wishing you Success,