What is considered a halal stock? In short, a stock that is listed on the stock exchange is termed Halal when it meets the Shariah screening criteria derived from the Holy Quran and Sunnah.
This article will introduce you to Shariah stock screening including a step-by-step guide explaining in detail what is Shariah stock screening methodology followed by a practical example (Tesla). There is multiple Shariah stock screening methodologies through the FTSE (Financial Times Stock Exchange Russell), AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) and DJIM (Dow Jones Islamic Market Index). The DJIM Shariah screening methodology was referenced for this article.
So, let’s dig right into it and learn more about Shariah stock screening.
Qualitative (Non-financial) Analysis
The first step of the Shariah stock screen process is to evaluate the nature of the business as discussed below.
Nature of the business
The first criteria and often easiest to evaluate is: How does the business make money?
The core value of the business must not fundamentally violate the laws of Shariah. Business’ that partake primarily in prohibited activities considered as “Haram” or impermissible are unequivocally screened out. Several examples of prohibited business activities include but not limited to buying and selling alcohol, pork, or tobacco, as well as various forms of entertainment such as casinos and nightclubs.
Beyond the above list of business activities, there are a few additional business sectors that are not as straightforward and require further analysis to assess Shariah compliance: the financial services and media industries.
In reality, not all businesses will have 100% halal sources of income, in these common circumstances, the 5% rule will apply, more on that in a bit.
Once you have vetted the nature of the business to assess Shariah compliance, the next step is to review the numbers (balance sheets, income to debt ratio, etc.)
The “5 percent” Rule
In reality, a lot of companies operate in both halal and non-halal business areas making it challenging to determine the permissibility of trading such stocks. The 5 percent rule dictates that companies with mixed sources of income can be permissible for purchase as long as the non-Shariah compliant portion of the company’s gross sales is less than 5 percent.
For many decades, Scholars have been discussing and debating the implications of these such companies because in reality, most companies do have an element of Haram business. The majority scholarly opinion as reflected in the halal stock screening methodology is to determine what are the core business sources of income. While companies partake in many business practices, it is important to quantify the non-compliant aspects and determine their percentage compared to the overall business. If the non-compliant Shariah practices equate to less than 5% of gross sales, then the stock passes the “nature of the business” test. If the non-compliant Shariah practices exceed 5% of gross sales, then the stock is considered impermissible for Muslims to purchase and invest in. In the case where there are non-compliant Shariah practices less than 5%, you will need to purify your investment. More on that later!
To calculate this ratio, you will need income from non-compliant Shariah activities and the gross revenue of the company. Publicly traded companies will provide details pertaining to their income statements within their annual and quarterly earnings reports.
Quantitative (financial) Analysis
Once you’ve determined the nature of the business, the next step is to dig deeper into the business’ finances. The purposes of these calculations are to assess the financial health and level of interest-earning activities of the business.
Notably, Islamic financial markets in different parts of the world use various ratios. The reasons behind this variation are the Islamic finance market size in those markets. As mentioned earlier in the article, the Dow Jones Islamic Market Index Shariah stock screening methodology was referenced in writing this article.
???? Cash and Interest-bearing securities to market Capitalization
Cash and interest-bearing securities are current assets. These assets can be easily converted into cash easily in less than one year, therefore, known as current assets.
Cash is a well-familiar asset; a company should have cash to meet urgent payment needs. Other than cash is the interest-bearing security. It is another highly liquid asset that can be converted into cash in a short period. Bank term deposits and short-term government bonds are an example of interest-bearing securities.
Cash + Interest-bearing Securities / Market Capitalization
The other part of this ratio is market capitalization. This tool allows the investors to evaluate the size of the company and compare it with competitors in the market.
Average market capitalization is calculated by multiplying the number of outstanding shares with the average monthly value of the stock price.
You can easily find the value of average market capitalization from any finance website like Yahoo finance
As mentioned above, the value of both current assets must not exceed the limit of 33% of market capitalization. The logic behind this ratio is the company must not be predominantly in cash. If the current asset exceeds the market value of the stock, it means you have to buy the stock of a company whose market value is less than the actual value. This less value of the stock will be tantamount to interest that is against the Shariah principles.
???? Accounts Receivable to Market Capitalization
Accounts receivable is the money owed by the debtors of the company. Accounts receivable can be either current or non-current. If an account receivable is a non-current asset, it means the receivables have a maturity of more than one year.
According to Shariah standards, Accounts receivable must not exceed the limit of 33% of market capitalization. Again the reason behind this threshold is to limit the cash proceeds of the company and encourages investing more in illiquid assets like machinery, land and buildings.
???? Debt to market capitalization ratio
There are many companies that are using conventional borrowing to run their business operations. This ratio calculates both long-term and short-term conventional debts disclosed by the company in its financial reports.
Just like short-term assets, short-term debts mature in one year. Conversely, long-term debts have a maturity of more than one year.
Even in conventional financing, this metric is widely used. This ratio explains the degree to which a company uses loans to finance its assets. The higher ratio explains the company is not generating enough revenue and emphasizing more on external debts. You can conclude that the higher the ratio, the higher the risk.
The limit for this ratio is 33%. The logic behind these criteria is to protect the right of investors from risky investments.
A Practical Example: TSLA (Tesla)
Can you scan Tesla as a Halal stock? Let’s find out
Criteria# 1 Nature of the business
Tesla revolutionized the auto industry with modernized and high-tech cars and renewable solutions like solar panels and solar roofs. The company manufactures and sells their product worldwide.
The nature of the business is to manufacture customer-oriented products and sell them in the market to make profit. The business model is in line with Shariah principles with no invasion of prohibited activities.
So, Tesla passes the number#1 criteria. Now, you can move on to the financial ratios of the company.
Note: For the financial ratio analysis of Tesla, you can use the most updated annual report 2021. That is available on the company’s website. In the absence of an annual report, you can use a quarterly report or prospectus of the company.
You will find loads of accounting and financial information in company’s annual report. For simplicity, you can use data from various financial websites where you can use summarized information in one place.
Criteria# 2 less than 5% Income from prohibited Shariah activities
For the latest financial information on Tesla, you can use Yahoo finance. Here you can see the income statement for 2021. To calculate the income from prohibited activities, you can find interest income from the income statement. From the same statement, you can find the gross revenue of the company.
As per the report, the company earned $.056 billion from interest activities. To check the threshold of 5%, divide it by the net income. Net income is $5.52 billion. By dividing$.056bn/$5.52bn*100=1.0146%, you can clearly see company earned 1.0146% from impure income. That is below the Shariah requirement of 5%.
Criteria# 3 Cash and Interest-bearing securities to market Capitalization < 33%
To calculate this ratio, you need to look into the balance sheet of the company. A balance sheet is a financial statement that comprises details of both assets and liabilities of the company.
As told above both Cash and interest-bearing securities are current assets of the company. Under the head of currants Asset, you can easily find the cash-in-hand amount and other short terms investments. The amount from cash and interest-bearing securities is $17.71 billion.
Now moving on to the market Capitalization of Tesla, the value is 942.53 bn. Simply divide $17.71bn/942.53bn*100; the ratio is 1.87%. The company is keeping liquid assets less than 33%. That also meets the Shariah standards.
Criteria# 4 Accounts Receivable to Market Capitalization<33%
Another current asset, you will find in the balance sheet of the company. The accounts receivable of Tesla are $1.91 billion. In the case of Tesla, there is only a current account receivable which is $1.9 billion, with no non-current accounts receivables.
Similarly, you will divide the Net accounts receivable by market capitalization. $1.91bn/$ 942.53b*100=.20%, .20% is below the Shariah screening standard.
Criteria# 5 Debt to Market Capitalization Ratio <33%
Moving on to the last ratio, you will calculate debts. How much debt Tesla has borrowed compared to the actual value of the company.
To know the value of short-term and long-term debts, you will move on to the liability section of the balance sheet. Here, you can find the total debts payable by the company. The total debts are $8.87 billion. $8.87bn/$942.53bn*100=.942%
Is Tesla a Halal stock?
Now let’s summarize the above information in one place and see if Tesla is a Halal stock
| Shariah Screening Criteria | Tesla Eligibility Results | Shariah Compliant or Not |
| 1-Business Nature | Motor Vehicle Manufacturers | Yes |
| 2- less than 5% of Income from prohibited Shariah activities | 1.0146%<5% | Yes |
| 3- Cash+ Interest bearing securities< 33% | 1.87%<33% | Yes |
| 4- Accounts Receivable / Average Market Capitalization < 33% | .20%<33% | Yes |
| 5- Interest-bearing debt to Average market Capitalization < 33% | .942%<33% | Yes |
After checking all the boxes, you can see Tesla meets all the Shariah stock screening criteria. It is safe to invest in Tesla if you are looking for Halal stocks in the USA.