Financial

Management

Islamic Finance
 5-2

Topics Covered
Introduction

Basic principles of Islamic finance

Islamic sources of finance

 5-3

Introduction
Islamic finance has the same purpose as other
forms of business finance except that it operates in
accordance with the principles if Islamic law
(Sharia).
 5-4

Basic principles
Principles of Islamic finance include:
Sharing of profits and losses.
No interest (riba) allowed.
Finance is restricted to Islamically accepted
transactions i.e. no investment in alcohol,
gambling etc.

Ethical and moral investing is encouraged

 5-5

Basic principles
Riba is defined as the excess paid by the borrower
over the original capital borrowed i.e the equivalent
to interest on a loan. Its literal translation is 'excess'.

Instead of interest being charged, returns are earned

by channeling funds into an underlying investment
activity, which will earn profit. The investor is
rewarded by a share in that profit, after a
management fee is deducted by the bank.
 5-6

Sources of Finance
The main sources of finance within the Islamic
banking model include:
Murabaha (trade credit)
Ijara (lease finance)
Sukuk (debt finance)
Mudaraba (equity finance)
Musharaka (venture capital)
 5-7

Sources of Finance
In Islamic Banking there are broadly 2
categories of financing techniques:

Fixed Income modes of finance murabaha,

ijara, sukuk

Equity modes of finance mudaraba,

musharaka
 5-8

Sources of finance
1. Murabaha
Murabaha is a form of trade credit or loan. The key
distinction between a murabaha and a loan is that with
a murabaha, the bank will take actual constructive or
physical ownership of the asset. The asset is then
sold onto the 'borrower' or 'buyer' for a profit but
they are allowed to pay the bank over a set number
of instalments. The period of the repayments could
be extended but no penalties or additional mark up
may be added by the bank. Early payment discounts
are not welcomed (and will not form part of the
contract) although the financier may choose (not
contract) to give discounts.
 5-9

Sources of finance
2. Ijara

Ijara is the equivalent of lease finance

It is defined as when the use of the underlying asset or
service is transferred for consideration. Under this
concept, the Bank makes available to the customer the
use of assets or equipment such as plant, office
automation, or motor vehicles for a fixed period and
price.
 5-10

Sources of finance
Some of the specifications of an Ijara contact include:
The use of the leased asset must be specified in the contract.
The lessor (the bank) is responsible for the major
maintenance of the underlying assets (ownership costs)
The lessee is held for maintaining the asset in good shape

An Islamic lease is more like an operating lease but

the redemption features may be structured to make it
similar to a finance lease.
 5-11

Sources of finance
3. Sukuk
Within other forms of business finance, a company can
issue tradable financial instruments to borrow money.
Key feature of these debt instruments are they:
Dont give voting rights in the company,
Give right to profits before distribution of profits to
shareholders
May include securities and guarantees over assets
Include interest based elements
 5-12

Short-term sources of finance

All of the above are prohibited under Islamic law.
Instead, Islamic bonds(or sukuk) are linked to an
underlying asset, such that a sukukholder is apartial
owner in the underlying assets and profit is linked to
the performance of the underlying asset.

So for example a sukukholder will participate in the

ownership of the company issuing the sukuk and has
a right to profits (but will equally bear their share of
any losses).
 5-13

Sources of finance
4. Mudaraba

Mudaraba is a special kind of partnership where one

partner gives money to another for investing it in a
commercial enterprise. The investment comes from the
first partner (who is called 'rab ul mal'), while the
management and work is an exclusive responsibility of
the other (who is called 'mudarib').
 5-14

Short-term sources of finance

The Mudaraba (profit sharing) is a contract, with one
party providing 100% of the capital and the other
party providing its specialist knowledge to invest the
capital and manage the investment project.
Profits generated are shared between the parties
according to a pre-agreed ratio. In a Mudaraba only
the lender of the money has to take losses.

This arrangement is therefore most closely aligned

with equity finance.
 5-15

Sources of finance
5. Musharaka
Musharaka is a relationship between two or more
parties, who contribute capital to a business, and
divide the net profit and loss pro rata. It is most
closely aligned with the concept of venture capital. All
providers of capital are entitled to participate in
management, but are not required to do so. The profit
is distributed among the partners in pre-agreed ratios,
while the loss is borne by each partner strictly in
proportion to their respective capital contributions.