by M. Omar Baig
Islamic Finance
Principles and
Applications
of Islamic Finance
Principle #1: The capital in an investment
cannot be guaranteed.
Scenario: Ahmad wants to start a food
truck business. He asks his friend
Muhammad for $50,000 needed for
the startup in exchange for 10% of the
profits generated from the business.
Muhammad agrees but also wants
half of the capital guaranteed in case
the business fails.
Ruling: Impermissible
Explanation: In Islamic Finance, it is
permissible for a person to earn profit
from investments but haram to profit
from a loan (as doing so would constitute
interest). The key difference
between a loan and an investment is
that the capital of loan is guaranteed
regardless of the success of the investment,
whereas in an investment there
is a chance that the entire capital may
be lost. Thus, Islam allows people to
profit in lieu of the risk they are taking
in investments but prohibits from
profiting without risking one’s capital.
Proof: Allah says which translates as
follows, “Allah has permitted trade
and prohibited interest” (2:275).
Practical applications: This principle
may be applicable to many venture
capital financing deals in which the
investor stipulates any guarantee
regarding the capital.
Principle #2: The profit rate in an investment
must be a fixed percentage
of the profit and cannot be a specific
amount or from a specific stream of
revenue.
Scenario: ‘Ayesha wants to start her
own bakery. She asks her brother
‘Ali for an investment of $20,000 in
exchange for all the revenue generated
from the cakes. The remaining
revenue generated from the remaining
deserts will belong to ‘Ayesha.
Ruling: Impermissible
Explanation: Fairness and justice are
key features in Islamic Finance. It
is for this reason that Islam would
prohibit any investment scenario in
which the business can make a profit,
but a partner may still potentially
earn nothing. In the aforementioned
scenario, imagine if all of the sales
in one particular month are all from
the cakes and no other desserts are
sold. ‘Ayesha would be in a position
in which she would have put forth all
of her effort in making the cakes but
earned no profit from it. Rather, all of
the earned profits would have gone
to ‘Ali.
It is for this reason, any profit ratio
agreed upon in an investment must
be a general percentage applicable
to all the revenue in the business. To
specify a specific revenue stream, a
specific time period of sales, etc. to
be exclusively for one partner poses
the risk that the other partner(s) may
receive nothing in return for their
efforts or capital risked. Hence, any
such stipulations would render the investment
non-compliant with Islamic
principles.
Proof: Rafi’ ibn Khadeej g narrates,
“During the time of the Messenger of
Allah a, people would provide their
land as capital in lieu of the yield
which grew near the banks of large
rivers, or the yield which grew near
the beginning of the water streams,
or the yield of specific parcels of land.
Thereafter, some of the harvest would
blossom and some would not. This
was the only method of land-leasing
people did, but the Messenger of
Allah a forbade it. However, if the
amount is guaranteed and known,
then there is no problem with it” (Abu
Dawud).
Practical applications: Many venture
capital financing deals may include
royalty payments on the sale of each
product. This royalty payment is due
whether the business earns a profit
or not and regardless of the amount
of profit the business generates. The
aforementioned principle illustrates
that such a financing structure would
be impermissible.
Principle #3: The loss in any investment
must be borne in accordance
with one’s stake in ownership (if the
partnership is on a specific item) or
24 January – February 2022 | AL-MADINAH