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SPECIAL REPORT: ISLAMIC FINANCE 1 and 2

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ISLAMIC FINANCE 1

Fundamentals of Islamic Finance 

The purpose of this article is to explain the fundamental principles and underlying philosophy of Islamic Finance, and to explore the possibilities of the implementation thereof in South Africa. Firstly, the philosophy and socio-economic rationale underpinning Islamic Finance will be introduced, as it will be difficult to appreciate the resultant financial techniques without an understanding and appreciation of these principles. The next step will be to compare the aims and objectives of Islamic Finance with that of conventional finance. This will, in turn, introduce the reader to the major points of difference between Islamic Finance and conventional finance. Having firmly established the philosophy, rationale and difference in approach of Islamic Finance, the different modes of financing in Islam will be explained, and examples given of their application. The status of certain conventional financial instruments in Islam will then be discussed, followed by a discussion of the application of Islamic Finance techniques to achieve specific financing objectives. Having explained the mechanism and application of Islamic Finance techniques, the focus will shift toward creating specific investment products, and risk/return profiles using these techniques as the building blocks. Finally the scope and possibility for application in South Africa and Africa will be examined, and the role of religious scholars and institutions will be examined and explained. A brief examination of the way forward for Islamic Finance in South Africa will conclude the article.

Contrary to popular belief, Islam does permit the making of a profit. In fact, profit forms the basis of the Islamic financial system, in that every technique of Islamic Finance allows for the making of a profit by the party that provides the risk capital, as well as the party that uses the capital. There are, however, conditions on the manner in which the profit is made, and Islam certainly does not espouse the making of a profit in any way that violates religious law or is harmful to the stakeholders inherent in the business or economic activity. Profits in Islam must be inclusionary and ethical. By inclusionary, it is meant that both the provider and user of capital need to assume risk, and share in rewards. The major tenent of Islamic Finance is that interest, in any way, shape or form is strictly and utterly prohibited. Islam regards interest financing as immoral and socially and economically harmful, for a number of reasons: the extension of credit increases money supply, which stimulates demand, but does not always result in real, tangible economic activity – resulting in a variety of economic ills such as inflation, continued unemployment, widening income gaps, etc. In Islamic financing, money is never the object of trade, and every transaction must involve a tangible, useable asset – therefore, the only way for an individual to increase his/her income is through undertaking greater trade, manufacturing or service provision. This emphasis on economic activity ensures that as money changes hands( from the provider to the user) , this change is accompanied by an increase in trade, manufacture, service provision and, as a result, employment. Greater economic activity will stimulate the need and development of infrastructure, basic services, etc. There are also strict requirements regarding the nature of profit sharing, the interaction between business partners, the types of businesses that may be invested in, prohibited activities, responsibility to the community and environment etc. Thus, while CSI and business ethics are very much flavour of the day in conventional finance, Islamic finance has been entrenching, in fact demanding, these qualities of business for over 1400 years. Islamic Finance is therefore built on divine principles, governing and enforcing accountability to stakeholders, moral behaviour, fairness, equality, promotion of free trade, the harnessing of resources through partnership as opposed to debt, etc.

The following underlying aims of Islamic Finance are the same as those of conventional finance:

  • To use the funds of surplus economic units to facilitate investment and asset allocation
  • To facilitate trade
  • To provide financial services
  • To create investment opportunities.

The difference, however, between Islamic Finance and conventional finance is in the manner in which it proceeds to meet its objectives. The basis of Islamic Finance is equity (through profit and loss sharing schemes) and rental income, whereas the pillar of conventional fiancé is debt (through interest). The Islamic financier/investor deals in physical assets, whereas the conventional financier deals mainly in paper assets. Therefore, an Islamic financier will assume the risk of the purpose of the funds he is investing, and share in pre-agreed ratios in the profit or loss resultant therefrom, while the conventional financier will only assume the risk of default of the entity or person to whom he is advancing funds, and the only upside that he will receive is the interest payable on the loan. Therefore, if the interest payable on a loan is 10% p.a, the conventional financier will receive a return of R10 000 000 on a R100 million loan, regardless of the trading profit generated from that amount. If the Islamic financier had agreed to a 40% share of the profit or loss in return for investing R100 million in the entity, and the entity generated a net profit of R30 million, the financier would receive R12 million in dividends (much more tax efficient than interest!). Thus, the Islamic financier assumes business and operational risk in exchange for higher profits.

Seven major transactions form the building blocks of Islamic Finance techniques:

  • Musharakah – this entails forming a partnership to undertake some economic activity.
  • Diminishing Musharakah – this entails one partner (or partners) buying out the interest of the other partner(s) over time, so that the interest of the other partner(s) in the venture diminishes.
  • Ijara – this entails the rental of a physical asset to another party.
  • Salam – this entails paying “now” for a commodity for delivery at some later, pre-agreed time.
  • Istisna – this entails paying “now” for delivery at some later, pre-agreed time for a commodity that has yet to come into existence.
  • Murabaha – this entails buying an asset, adding a fixed mark-up as profit, and then selling it either as an installment sale or
    at spot.
  • Mudaraba – this entails a form of partnership where one partner provides the capital and the other partner provides the skills.

It is crucial to note that there are numerous factors regarding the execution, nature of commodity, etc. of the above transactions that will affect its validity in terms of Shariah (Islamic religious law) – the above descriptions are meant to provide a broad, conceptual overview of the different permissible transactions. A complete discussion on the technical details and finer points of the above transactions are beyond the scope of this article.

It should now be obvious to the reader that any financial instrument or product involving the use of interest in any way is forbidden in Islam. But what about listed equity and derivatives? There are numerous equity funds that invest in listed equity and claim to be Shariah compliant. Worldwide, a screening mechanism and certain debt/equity ratios, dividend cleansing etc. are used to evaluate the suitability of a listed equity as a Shariah compliant investment. There are, however, scholars that render investing in listed equity to be forbidden, and some conservative scholars in South Africa agree – the important point, however, is to note that investing in listed equity has not recieved blanket approval as being permissible. Due to the fact that there is no physical underlying being traded (with a guarantee of exchange), any form of derivative is outlawed in Shariah. The precise reasons for the outlawing of derivatives are, again, beyond the scope of this article.

The true power of Islamic Finance comes to the fore when one considers the wide range of applications for the techniques described earlier. The possibilities are endless, but the following list gives a relatively comprehensive overview of the scope of application of the various Islamic Finance techniques listed earlier:

  • Murabaha – House Finance, Fixed Asset Finance
  • Musharakah – Venture Capital, Private Equity, Project Finance
  • Diminishing Musharakah – Venture Capital, Private Equity, House Finance
  • Ijara – Asset Finance
  • Salam – Agricultural Finance, Hedging
  • Istisna – Asset Finance, Trade Finance
  • Mudaraba – Venture Capital, Investment Funds

Diverse risk and payoff profiles can be created by constructing an investment portfolio consisting of investments using different modes of Islamic Financing. For example, an investor wanting regular income from his/her capital could buy assets and use an ijara agreement, whereby he/she would rent them out for a specified period of time at a specified monthly rental. An investor wanting high returns could enter into a musharakah agreement and buy a stake in a business. An investor wanting a balanced risk profile could invest half his money in an Ijara investment, and the other half in a Musharakah investment. Therefore, the principles of investment management, such as diversification, income versus capital growth, low risk versus high risk, sector diversification etc. will still apply to an Islamic investor, but the manner in which these objectives are achieved, as well as the investments used, will differ from conventional finance.

The scope of application of Islamic Finance in Africa and South Africa is enormous. Islamic Financing structures can be used to encourage SME development, provide affordable housing, finance infrastructure projects, facilitate BEE deals, etc. while always ensuring fair, ethical business practices aligned with an increase in real assets and employment. The role of Muslim scholars in sanctioning the validity of Islamic Finance products and transactions is vital, as seemingly unimportant details can change the Shariah status of a product or transaction. The problem at the moment is that there is no unified approval structure for the entire country; however, this will soon change. The Council of Muslim Theologians (Jamiatul Ulama Tvl) has a dedicated Economics and Finance Desk, and the day is not far off when a countrywide Islamic Financial Services Authority will regulate the use of the term “Shariah Compliant”. The way forward for Islamic Finance will emerge as entrepreneurs realise the scope of the potential market for Islamic products, and innovation and vision take hold of the country. Judging by the success of ethical funds worldwide, the need to bolster GDP in South Africa and with its intense focus on business ethics, Islamic Finance is going to become a permanent feature of South Africa and Africa’s economic landscape.

Ebrahim Patel BSc (Hons), MPhil,  MIFM is a director of The An Nakheel Group, consisting of a Shariah Property Fund, a Corporate Shariah Advisory company and Media company.

 

 

SPECIAL REPORT ISLAMIC FINANCE 2

Leverage in Islamic Finance

Leverage has become an important part of balance sheet management in the modern business world, as investors and business owners constantly seek to amplify the returns gained on funds invested by them. Essentially, the overriding objective in seeking out leverage is the ability to generate the highest return possible from investing as little of one’s own cash as possible. If the objective, then, is to lift the returns on equity capital to as high a point as possible, the next step would be to ask: “What is the most appropriate lever to achieve this?” The best way to address this question is to look at the drivers of Return on Equity (ROE). The Du Pont model breaks down ROE into the following components:

ROE = (Profit Margin) X (Total Asset Turnover) X (Equity Multiplier)

= (Net Income/Sales) X (Sales/Total Assets) X (Total Assets/
Total Equity)

Looking at the above identity, it becomes clear that by holding any two factors constant, and simultaneously increasing a third factor, or any combination thereof, ROE can be increased. Immediately, an enterprise can increase its ROE by increasing its profit margin, while keeping sales constant, or by increasing its sales while keeping total assets unchanged. The problem with the first approach is that its effect only works up to a point. If an enterprise is operating efficiently, in a competitive marketplace, its ability to increase profit margins and sales is very much a function of the operating conditions in which it finds itself. Therefore, while it is most possible to increase ROE by focusing on profit margins and asset turnover, the last factor, the equity multiplier, has to be introduced in conjunction with the first two factors in order to effect a sustained increase in ROE. The need for the three factors to work in conjunction can be seen from the fact that the different factors involve interplay between balance sheet and income statement items. The profit margin is calculated using income statement items, and the equity multiplier is calculated using balance sheet items. The asset turnover ratio involves dividing an income statement item by a balance sheet item. Therefore, any increase in assets must not decrease sales or net income, and any addition to assets should, in fact, result in higher sales. In other words, there has to be synergy between balance sheet management and operational efficiency. This is important because, in focusing on the equity multiplier as a driver of ROE, you have to increase the ratio of assets to equity.

Increasing the ratio of assets to equity involves acquiring assets using resources other than equity capital. In conventional finance, this usually involves using interest-bearing debt to acquire assets. However, if the ability of the asset to generate sales and improve profit margins is less than the interest payable on the asset, the net effect would be a lowering of net income, which would decrease the first ratio in the Du Pont identity, diluting the gains made on the equity multiplier. In addition, the asset turnover ratio would decrease, further nullifying the effect of the increase in the equity multiplier. Thus, in principle, to increase ROE, an enterprise will have to focus on adding suitably productive assets to its balance sheet without using equity capital.

From an Islamic point of view, there are the following ways to add assets to one’s balance sheet without using equity capital: one could lease an asset, one could buy assets on credit and pay for them using cashflows generated by the asset, or one could act as an intermediary and sell goods on a consignment basis. The first option, to lease assets, would involve using an Ijaarah (rental) transaction. It is important to note that, in Islamic finance, the lessor is responsible for all maintenance of the asset, and the risk of natural destruction lies with the lessor. The lessee is only responsible for applying reasonable due care in ensuring the safety of the asset and in paying a gross lease premium. Rentals, or lease premiums, in Islamic finance, are determined upfront for the duration of the lease and, once set, are not subject to any fluctuation. Thus, in an Islamic Finance context, a lessee will be paying a fixed amount for use of a particular asset. An example will illustrate the potential that Ijaarah contracts have for increasing an enterprises ROE.

Example:

Assume that an enterprise wants to expand its manufacturing operations, and such expansion will only require the addition of new equipment and not any additional staff or other expenditure. The current ROE of the enterprise is 20%, calculated as follows:

 

Net Profit

 

R   5,000,000

 

Equity

 

R 25,000,000

 

ROE

 

20%

 

 

There are two options available to the enterprise, either to purchase the new machinery for R15 million using equity capital, or rent the machinery for a fixed rental of R1,5 million p.a. Assuming a depreciation allowance of 20% p.a. and that the net profit of R5 million currently being generated is unaffected by the new machinery and the products and operations thereof, the result of leasing and owning the machinery are presented below:

 

Lease Scenario

 

Cash Invested via Equity

 

R                 0

 

Sales Generated

 

R   5,000,000

 

Gross Profit

 

R   3,000,000

 

Machinery Rental

 

R   1,500,000

 

Net Profit

 

R   1,065,000

 

Total Net Profit

 

R   6,065,000

 

Total Equity

 

R 25,000,000

 

ROE

 

20%

 

 

Purchasing Scenario

 

Cash Invested via Equity

 

R 15,000,000

 

Sales Generated

 

R   5,000,000

 

Gross Profit

 

R   3,000,000

 

Depreciation at 20%

 

R   3,000,000

 

Tax Payable

 

R                 0

 

Net Profit

 

R   3,000,000

 

Total Net Profit

 

R   8,000,000

 

Total Equity

 

R 40,000,000

 

ROE

 

20%

 

 

Thus, although the depreciation allowance in the case of ownership provides a tax shield, which increases net profit, and there is no obligation to pay rentals, the increase in net profit is not greater than the increase in equity. Ultimately, therefore, the ROE stays the same under the ownership scenario but increases under the leasing scenario. These results are not, however, absolute, and a change in lease pricing and profitability can actually make ownership the more attractive option. Assume that the sales generated amount to R8 million and that the rental on the machinery amounts to R4,5 million p.a. then the results are as follows:

Lease Scenario

 

Cash Invested via Equity

 

R                 0

 

Sales Generated

 

R   8,000,000

 

Gross Profit

 

R   5,000,000

 

Machinery Rental

 

R   4,500,000

 

Net Profit

 

R      355,000

 

Total Net Profit

 

R   5,355,000

 

Total Equity

 

R 25,000,000

 

ROE

 

21.42%

 

 

Purchasing Scenario

 

Cash Invested via Equity

 

R 15,000,000

 

Sales Generated

 

R   8,000,000

 

Gross Profit

 

R   5,000,000

 

Depreciation at 20%

 

R   3,000,000

 

Tax Payable

 

R      580,000

 

Net Profit

 

R   4,420,000

 

Total Net Profit

 

R   9,420,000

 

Total Equity

 

R 40,000,000

 

ROE

 

23.55%

 

 

An important note to bear in mind is that the net profit figure adds back depreciation to arrive at a true cash net profit, rather than a pure accounting net profit. It is assumed that all sales are strictly cash. Therefore, the lessor will most likely set his rentals at a level that gives the lessee a greater ROE than the ownership scenario for any given set of variables, or else the “leverage” to be gained from leasing will be negated.

Ijaarah contracts work well in introducing leverage by facilitating the acquisition of “leasable” productive fixed assets. But what about relatively current assets, such as stock in trade? In order to introduce leverage with regard to current assets for trade, the use of trade terms from suppliers and negotiating consignment orders from suppliers will enable an enterprise to hold inventory and trade the inventory, without outlaying additional cash.

Another way of obtaining leverage in Islamic Finance is when a transaction has different payoff profiles, and there are partners that each require one of these different profiles. Consider the following example:

Two parties want jointly to purchase a property worth R25 million, with a rental yield of 10% p.a. and a capital growth of 15% p.a. One party agrees to collect only rental income for 5 years and the other party agrees to collect the capital profit after selling the property in 5 years time. The rental partner requires regular income, whereas the capital partner requires lump sum payments every five years, to suit their respective cashflow requirements. Ordinarily, the rental partner would only earn a 10% p.a. yield (assuming no taxes, expenses or escalations) had it bought the entire building, and the capital partner would have earned a 15% p.a. capital growth. Arguably, the rental partner would have had access to the capital profits and the capital partner to the rental profits, earning them a compounded annual return of roughly 20% (assuming all rentals were collected together with capital at the end of 5 years, for purposes of calculation). Even with that, the splitting arrangement produces approximately a 2,5% higher ROE!!

Value of Property

 

R 25,000,000

 

Rental Yield p.a

 

10%

 

Capital Growth p.a

 

15%

 

Equity Contribution of Rental Partner

 

R 11,000,000

 

Equity Contribution of Capital Partner

 

R 14,000,000

 

Rental Earned Annually

 

R  2,500,000

 

Implied Rental Yield to Rental Partner

 

22.73%

 

Term of Partnership – Years

 

5

 

Value of Property After Term

 

R 50,283,930

 

Profit to Capital Partner

 

R 25,283,930

 

Implied Compounded Annual Return

 

22.92%

 

 

Thus by splitting different cashflow profiles, as well as having different timing requirements on when cash is paid to investors (beyond the scope of this article!), leverage can be created in an Islamic Finance framework. There is nothing wrong with leverage in Islamic finance, so long as the lever being used is a permissible transaction or agreement, and does not involve interest-bearing debt!!

Ebrahim Patel BSc (Hons), MPhil,  MIFM is a director of The An Nakheel Group, consisting of a Shariah Property Fund, a Corporate Shariah Advisory company and Media company.