AAOIFI screening: a practical guide

Very few listed companies are entirely free of interest. Most hold some cash in conventional banks and many carry some conventional debt. Shariah screening asks a narrower question: is this company's main business permissible, and is its exposure to interest small enough to tolerate? AAOIFI Shariah Standard No. 21, on financial papers, sets out the most widely used answer.

Test one: what the business does

The company's core activity must be permissible. Conventional banking and insurance, alcohol, pork, gambling, adult entertainment and similar activities fail this test no matter how clean the balance sheet is. A company whose main business passes can still have minor impermissible income, which the second test measures.

Test two: the financial ratios

• Interest-bearing debt must not exceed 30% of the company's market capitalisation.

• Cash and investments held in interest-bearing accounts or instruments must not exceed 30% of market capitalisation.

• Income from impermissible sources must not exceed 5% of total revenue.

These thresholds are tolerances, not approval. They exist because avoiding all contact with interest is not yet practical in most markets. A company that passes is acceptable to hold, but the impermissible part of its income still has to be dealt with.

Purification

If 2% of a company's income comes from impermissible sources, then 2% of the dividend an investor receives should be given to charity, without expecting any reward for it. Some scholars also require purification of capital gains; others do not. Fund managers usually calculate a purification ratio for each holding and report it to investors.

Screening in Pakistan

Pakistan's Shariah-compliant indices and Shariah advisers apply their own published criteria, which follow the same logic but measure some ratios against total assets rather than market value. When you compare screening results from different providers, check which method each one uses before drawing conclusions.

Ratios also change every quarter. A share that passed last year can fail after a large borrowing or a fall in its share price, which is why screening should be repeated, not done once.