Short-term and alternative finance - Islamic finance princip...

Learning Outcomes

After reading this article, you will be able to identify and explain the fundamental principles of Islamic finance, including the prohibition of interest (riba), and describe key Islamic financial instruments. You will understand how returns are generated without interest and compare Islamic finance with conventional methods, both in terms of structure and exam applications.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand alternative financing methods, especially the unique features and instruments of Islamic finance. Be prepared to:

• Explain the difference between Islamic and conventional finance, with a focus on the prohibition of interest (riba)
• Describe how Islamic financial institutions generate returns with reference to Shariah principles
• Identify and briefly discuss the key Islamic finance instruments used by businesses, such as Murabaha (trade credit), Ijara (lease finance), Mudaraba (equity finance), Sukuk (debt finance), and Musharaka (venture capital)
• Assess the practical business implications—advantages, limitations, and suitability—of Islamic financial instruments compared to conventional alternatives

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is not permitted under Islamic finance principles?
   1. Profit-sharing partnership
   2. Lease-based returns
   3. Earning interest on a loan
   4. Selling real assets for profit

2. What is riba in the context of Islamic finance, and why is it prohibited?

3. Match the following Islamic finance instruments to their conventional equivalents:

   • Murabaha i) Venture capital
   • Ijara ii) Lease finance
   • Mudaraba iii) Trade credit

4. Briefly explain how sukuk differs from a conventional corporate bond.

Introduction

Islamic finance offers alternatives to conventional banking in Muslim and non-Muslim countries alike. Unlike traditional banking, Islamic finance follows Shariah law, which prohibits riba (interest), requires risk-sharing, and emphasizes real asset backing and ethical transactions. Businesses may look to Islamic finance for ethical reasons, access to new markets, or to meet religious requirements. Understanding its principles and instruments is essential for ACCA FM.

Key Term: Islamic finance
The system of raising and deploying capital following Islamic (Shariah) law, which prohibits interest (riba) and requires transactions to be ethical and asset-backed.

PRINCIPLES OF ISLAMIC FINANCE

Prohibition of Riba (Interest)

The most distinctive feature of Islamic finance is the strict prohibition of riba—any predetermined, guaranteed interest paid on loans or deposits is forbidden. Instead, profits must be earned from real economic activity, not just money-lending.

Key Term: riba
Any guaranteed, predetermined return (interest) on loans, which is strictly prohibited under Shariah law.

Key Term: Shariah-compliant
Aligning financial transactions and products with Islamic law, by avoiding interest, excessive uncertainty, and prohibited (haram) activities.

Risk Sharing and Asset-Backing

Islamic finance is based on sharing risk and reward. Financial transactions must link to tangible economic activity—loans must have real asset backing. Contracts must avoid excessive uncertainty (gharar), gambling (maysir), and prohibited industries such as alcohol or gambling.

ISLAMIC FINANCIAL INSTRUMENTS

Islamic finance offers several principal instruments, each designed to comply with Shariah requirements and to generate returns through permissible means.

Murabaha (Trade Credit/Cost-Plus Financing)

In a murabaha transaction, the financier (usually a bank) buys an asset on behalf of a client and sells it to the client at an agreed profit margin, payable over time. No interest is involved—the profit is built into the price. The risk (and ownership) of the asset must temporarily be with the financier.

Key Term: Murabaha
A Shariah-compliant cost-plus sale where an asset is bought by the financier and sold to the customer at an agreed profit, paid in installments.

Ijara (Islamic Leasing)

Ijara is similar to conventional leasing. The financier buys an asset and leases it out to the client for a fixed rental. The asset remains the financier’s property, and rentals provide the financier’s return. At the end, the asset may be transferred to the client under a separate agreement.

Key Term: Ijara
A leasing arrangement under Shariah law where the financier owns the asset and the client pays rent for its use.

Sukuk (Islamic Bonds)

Sukuk are Islamic debt instruments. Instead of lending money for interest, investors buy a share of an asset or business, and receive returns linked to the asset’s performance. Sukuk holders are legal owners of the asset and share in profits (or losses).

Key Term: Sukuk
Shariah-compliant securities representing ownership in an asset, project, or business—returns are based on asset performance, not interest.

Mudaraba (Profit-Sharing Partnership/Equity Finance)

Mudaraba is a partnership where one party provides capital and the other provides management know-how. Profits are shared according to pre-agreed ratios; losses are borne only by the capital provider unless caused by negligence.

Key Term: Mudaraba
A contractual profit-sharing arrangement where one partner supplies capital and the other management; profits are shared, but only the investor bears financial loss.

Key Term: Musharaka
An equity partnership where all partners contribute capital and participate in management, sharing profits and losses according to agreed ratios.

Musharaka (Joint Venture/Venture Capital)

Musharaka contracts are joint ventures, where all partners contribute funds (and sometimes management/effort) and share profits and losses. This is commonly used for larger projects and investments.

HOW RETURNS ARE GENERATED

Instead of interest, Islamic financiers earn returns from:

• Asset sale mark-ups (Murabaha)
• Lease rentals (Ijara)
• Profit-sharing on real business ventures (Mudaraba, Musharaka)
• Asset-backed investment returns (Sukuk)

Worked Example 1.1

A company needs to purchase equipment but wants to avoid a conventional interest-bearing loan. The bank buys the $100,000 equipment and sells it to the company at $115,000, payable over 5 years.

Question: Is this arrangement compliant with Shariah law?

Answer:
Yes—this is murabaha. The bank’s profit ($15,000) replaces interest. The company pays the agreed total in installments, but there is no guaranteed interest rate. The sale has real asset backing and complies with Islamic finance.

Worked Example 1.2

A business seeks to raise $1 million to expand operations in a region with preference for Islamic finance. Should it issue a standard bond at 6% or consider sukuk?

Answer:
Standard bonds pay fixed interest and are prohibited under Islamic law. Sukuk allows the business to sell ownership interests in a profit-generating asset; investors receive returns linked to asset performance—not interest. Issuing sukuk would comply with Shariah and attract investment from this market.

Exam Warning

Many students confuse 'Islamic' finance with ethical investing or interest-free loans. In the exam, explain the prohibition of interest and how returns are generated (e.g., profit-sharing, leasing, asset sale), not merely 'interest-free'.

PRACTICAL IMPLICATIONS FOR BUSINESS

• Compliance: Businesses dealing with Muslim clients or markets may be required or expected to use Islamic finance.
• Documentation: Contracts must clearly set out ownership, risk, and profit-sharing terms.
• Asset requirement: Most transactions require the involvement or existence of real assets (not just cash flow).
• Risk: Some Islamic instruments transfer more risk to providers of capital compared to fixed-interest loans.
• Accessibility: Not all conventional products have direct Islamic equivalents (Working capital lines, overdrafts, etc., may need structuring).

Revision Tip

In multiple-choice and scenario questions, focus on identifying which party bears risk, whether there is a real asset involved, and if any return is a fixed interest or a share of profit.

Summary

Islamic finance prohibits interest and avoids pure money-lending. Instead, return on capital must arise from sharing the risks and rewards of genuine business or asset-based transactions. Key instruments—Murabaha, Ijara, Sukuk, Mudaraba, Musharaka—achieve this using trade, leasing, investment, and partnerships. For ACCA FM, be able to define, identify, and compare these instruments with conventional finance tools.

Key Point Checklist

This article has covered the following key knowledge points:

• The prohibition of riba and core Shariah principles in finance
• The basis for returns in Islamic finance (no interest, asset-backed)
• Structure, use, and exam focus of Murabaha, Ijara, Sukuk, Mudaraba, and Musharaka instruments
• Business implications—risk, documentation, and operational differences
• Key distinctions between Islamic and conventional finance for exam questions

Key Terms and Concepts

• Islamic finance
• riba
• Shariah-compliant
• Murabaha
• Ijara
• Sukuk
• Mudaraba
• Musharaka