Halal investing basics

Why a stock needs checking

A stock is a share in a company. That makes the shareholder a partner: whatever the company does and however it is financed, both the profit and the responsibility reach the partner. Islamic finance has three core prohibitions: riba (interest), gharar (excessive uncertainty) and maysir (gambling). Shariah screening measures how far a company stays from those lines.

In the real world, though, almost every company keeps money in a bank and most borrow. If the standard were an absolute "zero", hardly any listed stock would remain. So scholars developed a two-stage approach: zero tolerance on business activity and clear limits on financial structure. The most widely used is AAOIFI Standard No. 21.

Stage 1: business activity

First comes how the company makes its money. If its core business is one of the following, the stock is rejected no matter what its ratios look like:

• conventional (interest-based) banking, lending, mortgages, conventional insurance;
• alcohol, tobacco, pork products;
• gambling, casinos, betting platforms;
• adult content;
• weapons (on many screeners' lists).

Example: an interest-based bank may have no debt and a mountain of cash — but its core product is interest. It stops at stage 1; the ratios are not even calculated. The full list: blocked sectors.

Hidden and mixed activity

Sometimes the prohibited activity is not visible in the industry label: a pork producer may sit under "packaged foods", a weapons maker under "aerospace". That is why good screeners review such cases by hand. In other cases the prohibited activity is a small part of the business: a supermarket, say, where a little of its sales is alcohol. Such a company is not rejected automatically at stage 1 — that income is counted in the third ratio (impermissible income).

Stage 2: three financial ratios

A company with clean activity must then pass three ratios. Let's work through all of them on one sample company:

• market cap — $50bn;
• interest-bearing debt — $6bn;
• cash and interest-bearing securities — $4bn;
• annual revenue — $20bn, of which interest income is $300M.

1. Debt ratio: below 30%

Debt ratio = interest-bearing debt ÷ market cap = 6 ÷ 50 = 12%. It shows how much the company leans on riba-based borrowing. Above the limit, a material part of the business is financed with interest-bearing debt.

2. Interest-bearing assets: below 30%

Interest-bearing assets = (cash + short- and long-term interest-bearing securities) ÷ market cap = 4 ÷ 50 = 8%. This ratio answers: "Is this a real business, or a pile of cash earning interest?" Above the limit you are effectively investing in a deposit rather than a business.

3. Impermissible income: below 5%

Impermissible income = interest and other prohibited income ÷ total revenue = 300 ÷ 20,000 = 1.5%. AAOIFI treats up to 5% as incidental — but that part must be purified.

On the chart all three ratios sit well below the limit line — the company passes the financial stage. Let's take a closer look at the third ratio:

$300M of the $20bn in revenue came from interest on cash in the bank. It is a tiny slice, but not zero. If you receive a dividend from this company, you give 1.5% of it to charity — covered in detail in the Purification lesson.