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Section 1
What investing in stocks actually means
Buying ordinary shares makes you one of many shareholders of a public company (opens in a new tab). The shares represent ownership; the price on your screen is what buyers and sellers currently agree that ownership is worth.
How shareholders can earn
You can benefit in two main ways. A company may distribute some of its profits to shareholders as dividends. Your shares may also rise in value, allowing you to sell them for more than you paid.
Neither outcome is guaranteed. The company may pay no dividend, its share price may fall, and a business failure can destroy much or all of your investment. Owning shares means sharing in business risk as well as the possibility of reward.
Section 2
Why stock investing can be Shari'ah compliant
Participation in a permissible business
Business ownership can be permissible under Shari'ah. Shares make that ownership accessible without requiring you to establish or run the company yourself. AAOIFI (opens in a new tab) recognises that shares may be held to earn from the business or traded to benefit from price changes, subject to the relevant conditions.
Read reference: Participation in a permissible business
AAOIFI · Standard No. 21
It is permissible to buy and sell shares of corporations, on a spot or deferred basis in which delay is permissible, if the activity of the corporation is permissible irrespective of its being an investment (that is, the share is acquired with the aim of profiting from it) or dealing in it (that is, with the intention of benefiting from the difference in prices).
But ownership alone does not make every stock acceptable. The company's activities and finances must be examined, and the way you buy and sell must also be permissible. A permissible business does not make an interest-funded share purchase permissible.
The potential benefits
Stocks offer a way to participate in the growth of productive businesses and build wealth over time. You can also spread your investment across several businesses and industries, reducing dependence on any one company. Diversification (opens in a new tab) does not eliminate losses, but it can reduce the impact of an individual business failing.
For an investor seeking Shari'ah compliance, screening helps align these financial decisions with religious commitments. It gives you a framework for deciding which businesses you are willing to own.
Compliance and investment quality are different questions
A compliant company can still be poorly managed, financially weak or overpriced. Passing a Shari'ah screen answers whether a company meets that screening framework. Investment research asks whether its business, price and risks make it suitable for your goals. Both checks matter.
Section 3
Where we start with India's listed companies
In India, we start with companies listed on the National Stock Exchange, or NSE (opens in a new tab), and the Bombay Stock Exchange, or BSE (opens in a new tab). If you are more familiar with the US markets, think of their role as broadly comparable to exchanges such as the NYSE (opens in a new tab) and Nasdaq (opens in a new tab). Some Indian companies are listed on both exchanges.
We narrow this universe through two types of screening.
- Qualitative screening examines what a company does and how it operates. Its primary business is the main commercial activity it exists to carry out: for example, making medicines, selling software or lending money. A company may also have other activities that need separate review.
- Quantitative screening examines the financial numbers, including income sources, borrowing and assets. Companies that pass both layers form a list for further investment research.
Section 4
Understanding AAOIFI and the reasoning behind screening
What AAOIFI does
AAOIFI stands for the Accounting and Auditing Organization for Islamic Financial Institutions. It develops standards for Islamic finance. Its Shari'ah Standard No. 21 addresses shares and bonds, including conditions for investing in companies and rules for trading shares.
Explore AAOIFI's Shari'ah standards
Some companies have permissible business activities without interest-based borrowing or deposits. Others have a permissible primary business but also undertake prohibited financial transactions. A manufacturer, for example, might make useful household goods while earning interest on a bank deposit.
A company whose primary business is prohibited is a different case. Conventional interest-based banking does not become permissible simply because the bank also earns a small amount from another activity.
AAOIFI's standard begins from a rule prohibiting investment in companies that undertake prohibited transactions, then sets out a conditional exception for companies with permissible primary activities. The financial thresholds are part of that exception, alongside other requirements.
Read reference: What AAOIFI does
AAOIFI · Standard No. 21
- Participation or trading (for investment and trading) in the shares of corporations whose primary activity is permissible, but they make deposits or borrow on the basis of interest
- That the corporation does not state in its memorandum of association that one of its objectives is to deal in interest, or in prohibited goods or materials like pork (swine) and the like.
- That the collective amount raised as loan on interest - whether long-term or short-term debt - does not exceed 30% of the market capitalization of the corporation, knowingly that raising loans on interest is prohibited whatsoever the amount is.
- That the total amount of interest-taking deposits, whether short-, medium- or long-term, shall not exceed 30% of the market capitalization of total equity, knowingly that interest-taking deposits are prohibited whatsoever the collective amount is.
- That the amount of income generated from prohibited component does not exceed 5% of the total income of the corporation irrespective of the income being generated by undertaking a prohibited activity, by ownership of a prohibited asset or in some other way. If a source of income is not properly disclosed then more effort is to be exerted for identification thereof giving due care and caution in this respect.
- For the determination of these percentages, recourse is to be had to the last budget or verified financial position.
- It is obligatory to eliminate prohibited income specific to the share that is mixed up with the earnings of the corporations, and this in accordance with the following:
- The elimination of prohibited income is obligatory on one who is the owner of the share, whether an investor or a trader, at the end of the financial period, even if the payment is due at the time of issuance of the final financial statements whether quarterly, annual or for other period. Accordingly, elimination is not obligatory for one who sells the shares before the end of the financial period.
- The subject-matter of elimination is the prohibited income specific to the share whether or not the profits have been distributed and whether or not the corporation has declared a profit or suffered a loss.
- Elimination is not obligatory for the intermediary, agent or manager out of part of their commission or wages, because this is their right in lieu of the work they have undertaken.
- The figure, whose elimination is obligatory on the person dealing in shares, is arrived at by dividing the total prohibited income of the corporation whose shares are traded by the number of shares of the corporation, thus, the figure specific to each share is obtained. Thereafter the result is multiplied by the number of shares owned by the dealer - individual, institution, fund or another - and the result is what is to be eliminated as an obligation.
- It is not permissible to utilise the prohibited component in any way whatsoever nor is any legal fiction to be created to do so even if this is through the payment of taxes.
- The responsibility for elimination of the prohibited component of the income, for the benefit of all, falls upon the institution in case it is trading for itself or in case it is managing the operations. In the case of intermediation, however, it is bound to inform the person dealing in them of the mechanism for the elimination of the prohibited component so that he can undertake it himself. The institution may offer these services, with or without a charge, for those dealers who desire them.
- The institution will apply the above rules whether it does so directly or through another and whether it is trading for itself or for another by way of intermediation or management of wealth, like funds, or is doing so as the agent of another.
- It is necessary to observe these rules throughout the period of participation or trading. If the rules cannot be applied, it is obligatory to give up such investment.
Why this does not make interest permissible
The exception concerns whether you may invest in the company. It does not give the company permission to borrow or deposit money on interest. The standard explicitly maintains that these transactions are prohibited regardless of their size.
Read reference: Why this does not make interest permissible
AAOIFI · Standard No. 21
- That the collective amount raised as loan on interest - whether long-term or short-term debt - does not exceed 30% of the market capitalization of the corporation, knowingly that raising loans on interest is prohibited whatsoever the amount is.
- That the total amount of interest-taking deposits, whether short-, medium- or long-term, shall not exceed 30% of the market capitalization of total equity, knowingly that interest-taking deposits are prohibited whatsoever the collective amount is.
This distinction explains why screening and purification exist together. A company may qualify for the exception, but prohibited income attributable to the shareholder still has to be removed. A tolerance threshold is not an amount of prohibited income you may freely keep.
Why the percentages need context
The numbers provide boundaries for the conditional exception. They are not financial guarantees, nor do they replace an examination of the underlying business.
Section 5
How Shari'ah screening works
First examine the business
Start by identifying the company's main activity and the sources of its income. Straightforward examples of prohibited primary activities include producing alcoholic drinks, gambling and conventional interest-based banking.
Read reference: First examine the business
AAOIFI · Standard No. 21
The issuance of shares is permissible if the objectives for which the corporation was established are permissible according to the Shari'ah, thus, the objectives of its formation should not be transactions that are prohibited, like the manufacturing of liquor, trading in swine or transactions in Riba. If the objectives of the corporation are impermissible, the formation of the corporation is (not) permissible too, and consequentially so is the issuance of shares that constitute such a corporation.
That the corporation does not state in its memorandum of association that one of its objectives is to deal in interest, or in prohibited goods or materials like pork (swine) and the like.
That the collective amount raised as loan on interest - whether long-term or short-term debt - does not exceed 30% of the market capitalization of the corporation, knowingly that raising loans on interest is prohibited whatsoever the amount is.
Company names and broad industry labels are not enough. A business may operate several divisions, acquire a new subsidiary or earn additional income from investments. Reviewing its activities and financial disclosures helps reveal what lies behind its headline description.
Understand the numbers before the ratios
Market capitalisation (opens in a new tab) means the company's stock-market value: its share price multiplied by its outstanding shares (opens in a new tab). It changes as the share price changes.
Total assets (opens in a new tab) are the resources shown on the company's balance sheet, such as buildings, equipment, inventory, cash and money customers owe. Assets are not the same as market capitalisation.
Interest-bearing debt (opens in a new tab) is borrowing on which interest is payable. Total income concerns what the company earns; it is not the same as the profit remaining after expenses. Use the income definition required by the screening method rather than substituting net profit.
AAOIFI's main financial limits
For the conditional exception discussed above, Standard No. 21 sets out these limits. All must be satisfied, together with the other applicable conditions.
Read reference: AAOIFIs main financial limits
AAOIFI · Standard No. 21
- That the corporation does not state in its memorandum of association that one of its objectives is to deal in interest, or in prohibited goods or materials like pork (swine) and the like.
- That the collective amount raised as loan on interest - whether long-term or short-term debt - does not exceed 30% of the market capitalization of the corporation, knowingly that raising loans on interest is prohibited whatsoever the amount is.
- That the total amount of interest-taking deposits, whether short-, medium- or long-term, shall not exceed 30% of the market capitalization of total equity, knowingly that interest-taking deposits are prohibited whatsoever the collective amount is.
- That the amount of income generated from prohibited component does not exceed 5% of the total income of the corporation irrespective of the income being generated by undertaking a prohibited activity, by ownership of a prohibited asset or in some other way. If a source of income is not properly disclosed then more effort is to be exerted for identification thereof giving due care and caution in this respect.
- For the determination of these percentages, recourse is to be had to the last budget or verified financial position.
| Check | Calculation | Maximum |
|---|---|---|
| Interest-bearing borrowing | Short-term and long-term interest-bearing loans ÷ market capitalisation | 30% |
| Interest-taking deposits | Interest-taking deposits ÷ market capitalisation | 30% |
| Prohibited income | Prohibited income ÷ total income | 5% |
These are limits on different aspects of the company. A low prohibited-income ratio cannot compensate for excessive interest-bearing borrowing.
Why the assets themselves also matter
Shares represent ownership of the company's underlying assets. A business holding only cash, or only debts owed to it, raises different trading questions from an operating business with property, equipment and other assets.
AAOIFI therefore includes additional rules for asset composition and for companies dealing in currencies or similar assets. This is another reason why the three headline financial ratios alone are not a complete reproduction of the standard.
Read reference: Why the assets themselves also matter
AAOIFI · Standard No. 21
- It is not permissible to undertake trading in the shares of a corporation, when the assets of the corporation are cash exclusively, whether this is during the period of subscription or after that, prior to the commencement of the business of the company or at the time of liquidation, except at their nominal value and with the condition of delivery of possession.
- It is not permissible to undertake trading in the shares of a corporation if the entire assets of the corporation are composed of debts, unless the rules for dealing in debts are observed.
- If the assets of a corporation are composed of tangible assets, benefits, cash and debts, the rule for trading in the shares of such a corporation will differ according to the primary asset, which conforms to the objective of the corporation and its usual activity. If its purpose and activity pertain to trading in tangible assets, benefits and rights, trading in its shares is permissible without taking into account the rules of Sarf or transactions in debts, with the condition that the total market value of assets, benefits and rights should not be less than 30% of the total assets value of the corporation including all assets, benefits, rights and cash liquidity (the corporation's debts, current accounts with others, and bonds it holds which constitute debts) irrespective of their size as in such a case these are secondary. If, however, the objective of the corporation and its usual activity is dealing in gold, silver or currencies (Sirafah), it is obligatory to undertake trading in its shares in the light of the rules of Sarf.
- It is stipulated for the implementation of what is laid down in paragraph (It is not permissible to undertake trading in the shares of a corporation, when the assets of the corporation are cash exclusively, whether this is during the period of subscription or after that, prior to the commencement of the business of the company or at the time of liquidation, except at their nominal value and with the condition of delivery of possession.) that it shall not be adopted as a means for bargains in debts and trading in them by merging parts of tangible assets and benefits with the debts as a legal device for transaction in debts.
Compliance can change after you buy
A compliance result is a dated assessment, not a permanent quality of the company. A business can take on more borrowing, start a prohibited activity or receive more prohibited income. Where a test uses market capitalisation, a falling share price can change the ratio even if borrowing stays the same.
Review compliance as new financial statements and material business information become available. AAOIFI requires its conditions to be observed throughout the investment and requires the investment to be given up if they cannot be maintained. A past compliant label is not sufficient reason to continue holding indefinitely.
Read reference: Compliance can change after you buy
AAOIFI · Standard No. 21
It is necessary to observe these rules throughout the period of participation or trading. If the rules cannot be applied, it is obligatory to give up such investment.
Section 6
Purification and the investor's responsibility
Why purification is necessary
A company may pass screening while still earning a limited amount of prohibited income. As a shareholder, you have an attributable share of that income. Purification means removing the amount you are not entitled to retain.
Read reference: Why purification is necessary
AAOIFI · Standard No. 21
- It is obligatory to eliminate prohibited income specific to the share that is mixed up with the earnings of the corporations, and this in accordance with the following:
- The elimination of prohibited income is obligatory on one who is the owner of the share, whether an investor or a trader, at the end of the financial period, even if the payment is due at the time of issuance of the final financial statements whether quarterly, annual or for other period. Accordingly, elimination is not obligatory for one who sells the shares before the end of the financial period.
- The subject-matter of elimination is the prohibited income specific to the share whether or not the profits have been distributed and whether or not the corporation has declared a profit or suffered a loss.
- Elimination is not obligatory for the intermediary, agent or manager out of part of their commission or wages, because this is their right in lieu of the work they have undertaken.
- The figure, whose elimination is obligatory on the person dealing in shares, is arrived at by dividing the total prohibited income of the corporation whose shares are traded by the number of shares of the corporation, thus, the figure specific to each share is obtained. Thereafter the result is multiplied by the number of shares owned by the dealer - individual, institution, fund or another - and the result is what is to be eliminated as an obligation.
- It is not permissible to utilise the prohibited component in any way whatsoever nor is any legal fiction to be created to do so even if this is through the payment of taxes.
- The responsibility for elimination of the prohibited component of the income, for the benefit of all, falls upon the institution in case it is trading for itself or in case it is managing the operations. In the case of intermediation, however, it is bound to inform the person dealing in them of the mechanism for the elimination of the prohibited component so that he can undertake it himself. The institution may offer these services, with or without a charge, for those dealers who desire them.
It does not make a prohibited primary business acceptable, and it does not allow you to ignore a failed financial screen. Screening determines whether the investment is eligible; purification addresses the prohibited income attributable to an eligible holding.
How to calculate the amount
Under AAOIFI Standards, the calculation is:
Purification amount = (company's total prohibited income ÷ number of company shares) × number of shares you own.
Suppose a company earns ₹10 lakh of prohibited income during a financial period and has 1 crore shares. That works out to ₹0.10 per share. If you are responsible for purification on 1,000 shares for that period, the amount is ₹100.
Read reference: How to calculate the amount
AAOIFI · Standard No. 21
The figure, whose elimination is obligatory on the person dealing in shares, is arrived at by dividing the total prohibited income of the corporation whose shares are traded by the number of shares of the corporation, thus, the figure specific to each share is obtained. Thereafter the result is multiplied by the number of shares owned by the dealer - individual, institution, fund or another - and the result is what is to be eliminated as an obligation.
This is not a flat donation of 5% of your investment, dividends or capital gains (opens in a new tab). It uses the company's actual prohibited income attributable to your shares. The screening threshold and the purification calculation serve different purposes.
Who must purify and when
AAOIFI Standards place the obligation on the person who owns the shares at the end of the relevant financial period, whether an investor or a trader. It states that someone who sells before that period ends does not bear that period's obligation under this rule. The information needed to calculate the amount may only become available when the company issues its financial statements. The period may be quarterly, annual or another reporting period.
Read reference: Who must purify and when
AAOIFI · Standard No. 21
The elimination of prohibited income is obligatory on one who is the owner of the share, whether an investor or a trader, at the end of the financial period, even if the payment is due at the time of issuance of the final financial statements whether quarterly, annual or for other period. Accordingly, elimination is not obligatory for one who sells the shares before the end of the financial period.
For example, if you hold the shares at a 31 March financial year-end, you would use the relevant financial statements when available to calculate the amount due under this approach. Ownership at the period end determines responsibility; publication of the accounts provides the information needed to fulfil it.
Do not automatically combine overlapping quarterly and annual amounts, which could count the same income twice.
What if there is no dividend or the company makes a loss
The obligation concerns prohibited income attributable to the shares, whether or not it is distributed. Under AAOIFI Standard No. 21, it can therefore apply even if the company pays no dividend or reports an overall loss. A fall in your share price does not by itself cancel the obligation.
Read reference: What if there is no dividend or the company makes a loss
AAOIFI · Standard No. 21
The subject-matter of elimination is the prohibited income specific to the share whether or not the profits have been distributed and whether or not the corporation has declared a profit or suffered a loss.
What to do with the amount
Give away the amount for charitable purposes rather than retaining it for your own benefit. The standard prohibits using the prohibited component for personal purposes, including paying taxes. Keep a record of the calculation, the reporting period and the amount disposed of.
Read reference: What to do with the amount
AAOIFI · Standard No. 21
It is not permissible to utilise the prohibited component in any way whatsoever nor is any legal fiction to be created to do so even if this is through the payment of taxes.
Section 7
How Ethica Invest screens companies: three filters
Ethica Invest uses an adaptation of AAOIFI's guidance for its screening of Indian companies. Our quantitative screen uses the following three filters, all of which must pass. We also examine the company's business activities and conduct.
Our three financial filters
| Filter | Calculation | Maximum |
|---|---|---|
| Revenue ratio | (Questionable revenue + non-compliant revenue) ÷ total revenue | 3% |
| Interest-bearing debt ratio | Interest-bearing debt ÷ total assets | 30% |
| Liquid assets ratio | (Cash + short-term investments + net receivables) ÷ total assets | 90% |
An amount exactly equal to the stated limit passes that numerical test. Passing these tests does not override a disqualifying primary business or the qualitative review.
Revenue ratio
We review annual filings to identify the company's revenue sources and classify each as compliant, questionable or non-compliant. Interest income is a non-compliant source. We add questionable and non-compliant revenue together; the combined amount must not exceed 3% of total revenue.
For a company with ₹100 crore of total revenue, that means no more than ₹3 crore from these two categories combined. For example, ₹1 crore of questionable revenue and ₹1.5 crore of non-compliant revenue produce a ratio of 2.5%, which passes. A combined ₹3.5 crore would fail.
Interest-bearing debt ratio
We compare interest-bearing debt with total assets. If a company has ₹100 crore in total assets, its interest-bearing debt must not exceed ₹30 crore.
This examines interest-based borrowing relative to the company's asset base. It differs from AAOIFI's market-capitalisation denominator. This change is intended to make the requirements even more strict and remove the dependence on the market's expectation of future profits or a given company (PE ratio (opens in a new tab)) being used to calculate shari'ah compliance in the present scenario. A rule based on assets may not always be stricter in every case: the outcome depends on the relationship between the company's assets and its stock-market value.
Liquid assets ratio
For this filter, we define liquid assets as cash plus short-term investments plus net receivables. Net receivables broadly mean amounts owed to the company after relevant allowances for amounts it may not collect.
The ceiling ensures that at least 10% of assets fall outside those three categories. This is Ethica's defined asset-composition test.
Our additional ethical review
We also manually exclude companies known for human-rights violations, unethical conduct or environmental violations. At Ethica Invest, we believe how a business treats people and the environment is an important part of deciding whether to own it.
A company can pass numerical filters and still raise serious concerns about its conduct. Our qualitative review therefore goes beyond its financial ratios. After screening, business quality, valuation and investment risk still need separate assessment.
Section 8
Putting it into practice
Before buying
Check a company's current compliance assessment and understand the methodology behind it. Look at what the company actually does, then assess its business prospects, valuation and risks. Consider how the investment fits your goals and the rest of your portfolio.
While holding
Keep monitoring new results, borrowing, income sources and material changes in the business. Maintain the information needed for purification and act when a company no longer meets the relevant conditions. Shari'ah compliance is an ongoing responsibility, not a check completed once at purchase.
How you buy and sell matters
AAOIFI's standard prohibits buying shares with interest-bearing loans (opens in a new tab), selling shares you do not own through short selling (opens in a new tab), and entering share futures or options contracts (opens in a new tab). A compliant underlying company does not make these transactions permissible.
Read reference: How you buy and sell matters
AAOIFI · Standard No. 21
- It is not permissible to purchase shares by raising interest-bearing loans through a broker or another (margin sales), just as it is not permitted to mortgage the shares for such a loan.
- It is not permissible to sell shares that the seller does not own (short sale), and the promise of a broker to lend these at the time of delivery is of no consequence.
- It is not permissible to conclude futures contracts for shares.
- It is not permissible to conclude contracts of options for shares.
The practical approach is to understand what you own, apply a clear screening method, monitor it over time and fulfil the purification obligations that apply to you.
From principles to practice
Put our research to work for you
Understanding Shari'ah-compliant investing is one thing. Finding suitable companies, reviewing their financial statements and monitoring them over time takes ongoing work.
At Ethica Invest, we bring that research together through our services and ready-made model portfolios of carefully selected, Shari'ah-compliant stocks. Our approach combines compliance screening, ethical review and investment research to identify businesses with the potential to build wealth over the long term.
If you are new to investing
You do not have to begin by screening thousands of companies yourself. Our model portfolios give you a researched starting point, helping you move from understanding the principles to making informed investment decisions.
If you already invest
Our research can complement your own analysis and reduce the time you spend finding and reviewing investment opportunities. You gain access to a curated selection of companies, supported by ongoing monitoring of their compliance and investment prospects.
Research that continues after selection
A company's compliance, business performance and investment outlook can change. Our work continues beyond the initial recommendation, with ongoing review and updates to help you follow those developments.
We aim to identify investments that can generate attractive long-term returns. Returns are not guaranteed, and even a carefully researched, Shari'ah-compliant portfolio can experience losses.
Explore Ethica Invest's services and model portfolios on our website and choose the support that suits your investing journey.