Journal of Islamic Monetary Economics and Finance.
Vol.
No.
, pp.
759 - 786
p-ISSN: 2460-6146, e-ISSN: 2460-6618
THE LEVEL OF CONVERGENCE TO SHARIAoAH PRINCIPLES
AND CORPORATE PROFITABILITY
Deniz Parlak1.
Mehmet Emin Yildiz2 and Naci Ylmaz3 Dou yuniversity.
Tyrkiye, dparlak@dogus.
Bahyeehir yuniversity.
Tyrkiye, mehmeteminyildiz@eng.
Dou yuniversity.
Tyrkiye, nyilmaz@dogus.
ABSTRACT
This study constructs a ShariAoah convergence index for 1,362 companies operating in 10 different Islamic countries between 2017 and 2021 and assesses its relation to corporate ShariAoah screening variables are based on existing ShariAoah screening literature and applications, and variable weights are assigned using the Integrated Determination of Objective Ccriteria Weights (IDOCRIW) technique, a widely used, multi-criteria decision-making method.
The results suggest that 4% of the sample is completely non-compliant as they engage in non-permissible business activities, 82% has a non-compliant activity level below 30% and the remaining 14% has a noncompliant activity level between 41 and 99%.
Our panel data regression analysis shows that, while the ShariAoah convergence index does not affect operating profitability, it does have a statistically positive effect on total corporate profitability.
These findings are attributable to two factors, interest burden and debt level.
It seems that, for Islamic companies.
The high cost of debt service may offset the advantage of high leverage on Keywords: ShariAoah convergence.
ShariAoah screening.
Multi-criteria decision-making.
Return on assets.
Return on equity.
JEL classification: C33.
G24.
G31.
G32.
L25.
Article history:
Received : August 22, 2024 Revised : September 6, 2024 Accepted : November 30, 2024 Available online : December 24, 2024 https://doi.
org/10.
21098/jimf.
The Level of Convergence to ShariAoah Principles and Corporate Profitability INTRODUCTION In recent years, with the progress of financial technologies, many new financial investment tools have become available to investors, in addition to conventional financial assets.
However, investors influenced by Islamic economic principles only include in their investment portfolios assets which comply with ShariAoah, and given the return potential, investment in stocks remains one of the most preferred investment options for Muslim community.
The ShariAoah principles permit investments only in stocks of issuers that comply with Islamic rules with respect to their main activities, financing criteria, and investment decisions.
Given that conventional and Islamic financial systems are practiced simultaneously in many of the countries where more than 90 percent of the population are Muslim.
ShariAoah screening is required to determine which stocks are acceptable to investors with Islamic concerns.
Many global financial institutions that offer Shari-ah compliant financial assets apply screening criteria which they develop based on ShariAoah principles.
addition, stock exchanges and other organizations offer methodologies for ShariAoah In general.
ShariAoah screening is applied as a two-step process, where in the first step, the companies with main business activities that are non-permissible by Islamic principles are identified, and at the second step, the companies are checked according to their indebtedness, liquidity, interest income, and nonpermissible income levels.
However, there are considerable differences among screening methodologies in terms of debt, liquidity, interest, and non-permissible income measures employed, and in the thresholds applied.
In the literature, there are studies comparing ShariAoah screening criteria of various practitioners.
Khatkhatay & Nisar .
compare the ShariAoah screening processes of Dow Jones.
Malaysian Securities Commission, and Meezan Pakistan indices, while Pok .
compares those of Malaysian Securities Commission.
Dow Jones.
Financial Times, and Standard & PoorAos indices.
Derigs & Marzban .
cover Dow Jones.
Financial Times.
Standard & PoorAos.
Morgan & Stanley.
HSBC.
Amiri.
Dubai slamic Bank and Azzad & Meezan indices, whereas Bin Mahfouz & Ahmed .
analyze Dow Jones.
Financial Times.
Standard & PoorAos.
Morgan & Stanley and Malaysian Securities CommissionAos ShariAoah screening Still, the most detailed study on the subject is by Ho .
In the study, 34 Islamic finance indices are compared with respect to their screening criteria and the similarities and differences among them.
The comparison shows that in qualitative screening, several conservative institutions classify companies that involve in non-permissible activities as ShariAoah non-compliant, while more liberal institutions accept companies engaging in non-permissible activities as compliant, if the ratio of non-permissible income to total revenue, is below 5%.
For the debt screening, either total liabilities or interest-bearing liabilities are employed as the numerator, whereas in the liquidity screening, either accounts receivable, or accounts receivable plus cash, is employed as the numerator.
Interest screening, on the other hand, is measured either with interest income or cash plus interest bearing securities.
While some indices prefer to use average market capitalization as the denominator of all ratios, others use either total assets or market value of Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 By taking into consideration all screening criteria.
Ho .
classifies Dow Jones.
Azzad and BM Hijrah as the most conservative indices.
This classification fully confirms the findings of the four studies listed in the first paragraph of this section.
Kafou & Chakir .
reach the same findings as Ho .
by analyzing Moroccan All Shares Index with Dow Jones.
Financial Times.
Standard & PoorAos.
Morgan Stanley and STOXX indices, and conclude that for quantitative screening, the STOXX committee is the most liberal and Dow Jones the most conservative.
Meanwhile.
Hanif .
compare the Accounting and Auditing Organization for Islamic Financial Institutions, and Dow Jones.
Bursa Malaysia.
Financial Times.
Standard & PoorAos.
Morgan Stanley.
Thompson Reuters.
STOXX, and ISRA Bloomberg indices, and draw the same conclusions as the previous studies and explain the reason of the differences amongst the financial institutions with the following remarks:
A AuModern finance and investment is a new phenomenon and hence, the current practice is based on ijtihad of contemporary scholars who have different Shariah opinions.
Ay A AuThere is no higher Islamic authority that is responsible for religious rulings to be followed by all Muslims.
Ay The ranking of companies with respect to their ShariAoah convergence levels is investigated by Hanif .
and Orhan & Iker .
Hanif after reviewing the existing screening methodologies concludes that in terms of ShariAoah compliance, the screening of non-permissible income should have the highest weight, and liquidity should have the lowest whereas indebtedness and interest should have similar weights which falls between permissible income and liquidity.
Consequently, he proposes the weights of 20% for liquidity, 25% for debt, 25% for interest, and 30% for non-permissible income screening.
The author however, does not make any empirical research to test the proposed weights.
On the other hand.
Orhan & Iker .
after a detailed analysis of the existing literature and applications conclude that ShariAoah scholars do not accept any differences among quantitative criteria, and so they propose an equal weight for each screen.
The authors apply their methodology to a small dataset consisting of 20 Turkish firms for three consecutive years between 2017 and 2019, and they do not include liquidity screening in their empirical methodology since Turkish indices omit that The aim of all ShariAoah screening methodologies is to determine whether a stock is ShariAoah compliant or not, but they do not give any information about the level of compliance of the issuing company.
As such, the first purpose of this study is to determine the level of compliance of issuers to Islamic principles by developing a ShariAoah convergence ranking methodology.
On this purpose a dataset consisting of 1,362 companies from 10 different countries over a five-year period between 2017 and 2021 is employed.
Given the significant differences in the ShariAoah screening methodologies of financial institutions, in the context of this study, the variables used in the ranking are determined with a review of existing screening criteria applications, and the weights of variables are calculated objectively by applying the Integrated Determination of Objective Criteria Weights (IDOCRIW) method which is a well-known multi-criteria-decision making technique.
The debt level, liquidity level and non-permissible income level are the principal determinants of ShariAoah convergence, and all these factors have The Level of Convergence to ShariAoah Principles and Corporate Profitability important implications on corporate profitability.
Islamic principles favor lower cash and receivables level and prefer that returns be gained to a high extent from illiquid assets such as inventory and fixed assets.
While the amount of liquid assets shows the capacity of a company in meeting its short-term liabilites, the effect on profitability is negative as liquid assets consist of low return investments which do not result in an increase in production or sales (Durrah et al.
, 2.
Based on Baranek .
, the level of liquidity represents a tradeoff between the lower profitability of current assets and the financial flexibility it offers.
Islamic principles favor higher equity levels and accept equity as the main source of financing the corporate investments.
The amount of debt level that formulates the capital structure decision of the corporations is studied by different theories.
Myers & Majluf, .
, in their pecking order theory suggest that leverage and profitability are negatively related, whereas Jensen .
in his free cash flow theory suggests that debt reduces the agency cost of free cash flow and so leverage, and profitability are positively related.
Finally, the trade-off theory states that the optimal capital structure is attained at the point where the gains from the tax advantage of interest equals the cost of financial distress.
Finally, the formula developed by DuPont de Nemours.
Inc.
, commonly shortened to DuPont formula shows that to maximize return on equity firms must borrow up to the point where the cost of debt equals to the return on investment.
The relationship between ShariAoah compliance and profitability is analyzed in several studies.
Pepis & de Jong .
analyze the mentioned relationship on 664 firms for the period between 1990-2018 and conclude that Shariah-compliance positively affects long term profitability measured with return on assets and return on sales.
Saba et al.
by analyzing 941 Malaysian firms for the period between 2000-2013 show that ShariAoah compliant firms have higher ROA.
ROE and growth rate compared to non-ShariAoah-compliant firms.
Farroq & Alahkam .
in their study on the Middle East and North African region show that when performance is measured with market-adjusted returns, non-ShariAoah-compliant firms perform better compared to ShariAoah-compliant firms.
The studies that investigate the relationship between ShariAoah compliance and corporate profitability disclose conflicting results.
The aim of this study is to investigate the relationship between not ShariAoah compliance but ShariAoah convergence level and corporate profitability, which to our knowledge has not been tested before in the previous literature.
The large dataset consisting of 1,362 companies, is an important strength of the study.
The remaining of the paper is structured as follows.
The next section presents variables, data and methods used in the analysis.
Section 3 presents and discussed the results.
Finally, section 4 concludes the paper.
II.
VARIABLES.
METHODOLOGY AND DATA
Variables This paper aims to construct a ShariAoah convergence index for non-financial corporations and to investigate the relationship between the degree of convergence to Islamic rules and corporate profitability.
For this purpose, a set of variables to Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 measure convergence to ShariAoah principles and another set to measure profitability are required.
Many financial institutions apply ShariAoah screening processes to determine the stocks to be included either in the Islamic indices or in ShariAoah compliant mutual The widely used screening methodologies are developed by Dow Jones (DJIMI).
Financial Times (FTSE).
Morgan & Stanley Capital International (MSCI).
Standard & PoorAosAo (S&P).
Hong-Kong and Shanghai Bank (HSBC), and Thomson Reuters (T&R).
In addition, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), an institution responsible for the development and issuance of standards for the global Islamic finance sector, has also developed its own metrics for ShariAoah screening.
These institutions apply a qualitative and quantitative two-step process.
First in qualitative screening, companies with nonpermissible business activities by ShariAoah rules are identified and categorized as ShariAoah non-compliant.
The business activities that are classified as non-compliant by the above-listed institutions are presented in Table 1.
Table 1.
Non-compliant Business Activities Alcohol Broadcasting & Media .
xcept newspaper.
Conventional finance Gambling Hotels, restaurants & bars Pork related products Tobacco Weapons and defense Biotechnology Silver and gold .
DJIMI
FTSE
MSCI
S&P
HSBC
T&R
AAOIFI
The biotechnology industry is classified as non-ShariAoah compliant only by HSBC, whereas all other industries are classified as non-compliant by at least four out of seven institutions.
Hence, in the context of this study all companies which engage in business activities listed in Table 2, excluding the biotechnology industry, are classified as ShariAoah non-compliant.
The second step in the ShariAoah screening process is quantitative and involves the calculation of a set of ratios to assess convergence to Islamic rules.
Quantitative screening consists of four categories which are debt, liquidity, interest, and nonpermissible income.
The metrics employed for each of these categories by seven previously-mentioned institutions are presented in Table 2 while differences in the denominator of the ratios applied is summarized in Table 3.
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 2.
Quantitative Screening DEBT SCREEN
DJIMI
total debt / average market capitalization <33% LIQUIDITY SCREEN
INTEREST
SCREEN
account receivables / average market capitalization <33% .
ash marketable securities with interes.
/ average market capitalization <33% .
ash marketable securities with interes.
/ total assets <30% interest income / total revenue<5% .
ash marketable securities with interes.
/ total assets <33.
FTSE
total debt / total assets <33% .
ash account receivable.
/ total assets <50% MSCI total debt / total assets <33.
account receivables / total assets <33.
total debt / market value of equity<33% account receivables / market value of equity <49% total debt / average market capitalization <33% account receivables / average market capitalization <33% T&R interest-bearing debt / average market capitalization <30% .
ash account / total assets <67% AAOIFI interest-bearing debt / average market capitalization <30% .
ash account / average market capitalization <70% S&P HSBC ash marketable securities with interes.
/ market value of equity <33% .
ash marketable securities with interes.
/ average market capitalization <33% .
ash marketable securities with interes.
/average market capitalization <30% .
ash marketable securities with interes.
/ average market capitalization <30% NONPERMISSIBLE
INCOME
SCREEN
N/A
income / total revenue<5% income / total revenue<5% income / total revenue<5% N/A N/A N/A Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 3.
Denominator Difference INSTITUTION DIJIMI.
HSBC.
AAOIFI
FTSE and MSCI
S&P
T&R
DENOMINATOR
Average market capitalization Total assets Market value of equity Average market capitalization.
for debt & interest screens Total assets for income screen As can be noticed at Table 2, there are important differences across institutions, not only in the formula of the calculated metrics, but also in the thresholds applied.
From Table 3, average market capitalization and market value of equity are the two market driven variables employed in the denominator by DIJIMI.
HSBC.
AAOIFI and S&P.
The use of market value data for the computation of the ratios has two important shortcomings.
First, even if the market value is supposed to provide the real value of the company it is very frequently pronounced and empirically showed that all markets in general, and emerging markets especially, are not always efficient and driven by irrational investors which creates an inconsistency And second, according to Islamic principles, only factors that are entirely under the control of the company should be considered (Derig & Marzban, 2008.
Hanif, 2.
As market-based data is not under full control of the firm, it cannot be treated as endogenous.
Given these issues, in the context of this study, total assets are used in the computation of all ratios.
For the numerator of debt screening ratios, the two variables employed are interest bearing debt and total debt.
Islam strictly prohibits interest-bearing debt, but at the same time favors equity in financing of investments.
As such, to pass ShariAoah screening, companies need to keep both financial and non-financial debt that they use to finance their assets within the accepted limits (Derig & Marzban.
So, given that both interest-bearing and total debt are expected to not exceed certain limits, two ratios are used in this study for debt screening.
These are the ratio of total debt to total assets (DS.
and the ratio of interest-bearing debt to total assets (DS.
For the numerator of liquidity screening ratios, the two variables employed are account receivables and account receivables plus cash.
According to the ShariAoah, returns should be earned from illiquid investments and consequently for a ShariAoah compliant company the share of inventory and fixed assets in total assets should be large.
(Hanif, 2.
Given that cash and account receivables are the most liquid assets, liquidity screen (LS) is measured using cash plus account receivables as a ratio of total assets.
Note that all financial institutions employ the sum of cash and marketable securities with interest for the numerator of interest screening ratios.
FTSE
however, adds a second ratio to measure interest, which is the ratio of interest income to total revenue.
Consequently, in this study two measures were employed to measure interest screen.
These are:
Interest Screen (IS.
= (Cash Marketable securities .
ith interes.
) / Total Assets Interest Screen (IS.
= Interest Income / Total revenue The Level of Convergence to ShariAoah Principles and Corporate Profitability In some instances, the corporations engage in ShariAoah permissible main business activities and non-permissible secondary business activities.
If this is the case, some financial institutions classify all firms which engage in Shari-ah non-permissible primary or secondary activities as non-compliant whereas others examine the amount of revenue from non-permissible activities by dividing the income from non-compliant activities to total revenue and classify the corporation as non-compliant if the mentioned ratio exceeds 5 percent.
In the context of this study in line with DIJMI.
HSBC.
T&R, and AAOIFI, all firms which engage in non-permissible primary or secondary business activities are classified as noncompliant.
For all ratios, the seven institutions differ in the thresholds they apply.
However, as the first aim of this study is to categorize the firms according to their convergence to ShariAoah principles and not ShariAoah screening, the benchmarks and thresholds are insignificant.
To measure profitability, the frequently used measures within the literature are return on equity (ROE) and return on assets (ROA).
ROE shows the return on capital invested by company owners and is defined as the ratio of net income to total equity.
To compute total equity, either year-end values or average values are employed (Monteiro, 2006.
Rappaport, 1.
ROA on the other hand, shows profit generating potential of companyAos assets.
There are two different approaches for computing ROA, either as the ratio of net income to total assets or the ratio of earnings before interest and taxes (EBIT) to total assets.
The first measure is frequently criticized, as the numerator .
, net incom.
is the return attributed to equity holders, and the denominator .
total asset.
is the investments of both equity and debtholders (Jewell & Mankin, 2.
Similar to ROE, total assets are computed with either year-end values or average values (Tissen & Sneidere, 2.
As a result, in this study.
ROE and ROA are measured respectively as the ratio of net income to average total equity and the ratio of EBIT to average total assets.
Aerage total equity for ROE and average total assets for ROA are computed by taking arithmetic means of the present and prior year data.
The control variable of the study is size.
As a general approach, size is added to the studies by taking the natural logarithm of either total sales revenue or total However, as the dataset of the present study consists of companies from 10 different countries which disclose financial results in their local currencies, rather than using absolute values, size is measured as a ratio by dividing sales revenue by gross domestic product (GDP) of the relevant country and relevant Three other dummy variables of country, industry and covid 19 are added to the regression equation.
The variables of the study are summarized in Table 4.
Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 4.
The Variables ABBREVIATION
ROE
ROA
SIZESAL
COUNT
IND
COVID
NAME
DEFINITION
Return on Equity Return on Assets Size 2 Country Industry Covid 19 Net Income / Average Total Equity EBIT /Average Total Assets Sales Revenue / GDP Country code Industry code 0 for years 2017,2018,2018.
1 for years 2020,2021 Methodology The first purpose of this study is to develop a ShariAoah convergence ranking methodology for non-financial firms.
In developing the ranking methodology, the critical issue is to determine the weights to be given to each of five ShariAoah compliance ratios.
On this purpose, multi-criteria-decision making techniques aim to rank the variables when multiple criteria need to be considered together.
Among different techniques the IDOCRIW technique being a combination of ENTROPY and the Criterion Impact Loss (CILOS) techniques enables strengths of one method to offset the weaknesses of the other.
Consequently, the IDOCRIW technique is employed in this study to assign weights to the variables defined in the earlier sections.
The ENTROPY technique, first introduced by Claude Shannon as a measure of uncertainty, is applied in six steps (Zhang et al.
, 2011.
Karami & Johansson, 2.
These steps are:
The decision matrix is prepared.
The decision matrix is normalized.
The shares in total are computed and results are organized in a matrix.
Using the ENTROPY coefficient of the normalized values, the ENTROPY values are calculated The Degree of Differentiation of the Information which indicates the distance from the ideal value is calculated The criterion weights .
are calculated.
Introduced by Mirkin in 1974, the Criterion Impact Loss (CILOS) technique takes the largest or smallest optimal value of one criterion and calculates the loss of importance .
of the other criteria.
It is also applied in six steps.
(Zavadskas.
Cereska et al.
, 2.
The decision matrix is transformed into a benefit-oriented matrix.
All criteria in the decision matrix are anticipated to be benefit-oriented, if there are cost-oriented criteria, they are converted to benefit-oriented by dividing the alternative with the minimum value in the criterion by the values in the The decision matrix is normalized AuSquare Matrix RAy is prepared by sorting the rows to each column from maximum to minimum according to values in the rows.
The data in the diagonals of the matrix R shows the best values for all criteria.
The Level of Convergence to ShariAoah Principles and Corporate Profitability AuSquare Matrix PAy is prepared.
The matrix P shows the loss of each criterion relative to the most important criterion The square matrix F is prepared.
In the matrix the criterion significance degrees .
are calculated, and the computed values indicate the criterion importance degrees due to normalization.
CILOS weights are calculated by solving the F matrix.
The IDOCRIW technique is applied by combining the weights calculated with ENTROPY and CILOS techniques.
In this method, the aggregate weights are calculated with equation 1.
represents the weights assigned by CILOS while .
represents those assigned by ENTROPY.
The variability of the criterion in the ENTROPY method and the loss of criterion effect in CILOS are balancing factors in the IDOCRIW (Zavadskas & Podvezko, 2.
The second purpose of the present paper is to examine the relationship between profitability and the degree of convergence to ShariAoah rules.
For this purpose, an unbalanced panel data regression analysis is applied.
In the context of this study, in order to control for time-invariant, firm-specific effects, and unbalanced structure, fixed effect model is used as it is consistent in the literature.
(Baltagi.
Wooldridge, 2010.
Yalama, 2013.
Ullah et al.
, 2.
In the analysis, the following panel regressions are used:
where ROEi,t is the return on equity of stock i at period t.
ROAi,t is the return on asset of stock i at period t.
IDOCRIWi,t ShariAoah convergence ranking criteria for stock i at time period t.
SIZESALi,t is the size ratio of stock i at period t.
COUNTi is country dummy.
INDi is industry dummy.
COVID is dummy for covid 19, and ui,t is the error term.
Data The dataset used in this study consists of manufacturing, service and technology companies established in Islamic countries.
Presently, there are about 30 countries If the panel has a short T, a fixed effects model could be more suitable.
Dynamic models generally need a greater number of time periods (T) compared to the number of cross-sectional units (N) to yield reliable estimates.
(Wooldridge, 2.
Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 across the globe in which more than 90% of the population are Muslim.
Of these 30 countries, only 12 utilizing international financial reporting standards in accounting applications are included in this current study to ensure the consistency of the data, which are gathered from the financial statements of the companies.
the data are obtained from national stock exchange websites, the two countries of Azerbaijan and Nigeria are omitted as they have very few non-financial industry firms listed in their stock exchanges.
The final list consisted of 10 countries, which are Bahrain.
Bangladesh.
Jordan.
Kuwait.
Malaysia.
Oman.
Pakistan.
Qatar.
Tyrkiye, and the United Arab Emirates.
Only non-financial companies which are listed on national stock exchanges for all five years between 2017 and 2021 are included to the analysis.
The final sample consists of 6,810 observations of the 1,362 firms over a five-year period .
The company list and company-specific data have been collected from the official websites of national stock exchanges, with each classifying industries However, given that Malaysian firms have the largest share of the sample, all firms in the sample were categorized according to Bursa MalaysiaAos industry classification.
Due to limited number of observations.
Bahrain.
Jordan.
Kuwait.
Oman.
Qatar, and the United Arab Emirates are grouped in one single category named the Middle East.
The final sample consists of companies from five different geographical regions, which are Bangladesh.
Malaysia, the Middle East.
Pakistan, and Tyrkiye.
The country and industry classification of the dataset is presented in Table 5.
Table 5.
The Sample CODE
INDUSTRY
food and beverage textile and leather
automotive parts and ship building building materials and glass
personal care, wood and furniture paper and home appliances and equipment equipment and equipment and BANGLADESH MALAYSIA
MIDDLE
EAST
PAKISTAN
TyuRKYE
TOTAL
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 5.
The Sample (Continue.
CODE
INDUSTRY
oil and gas
technology and consumer and industrial services transportation and digital services, software and gas, water and TOTAL
BANGLADESH MALAYSIA
MIDDLE
EAST
PAKISTAN
TyuRKYE
TOTAL
The data for all variables have been gathered from financial statements and the foot notes disclosed by companies which were obtained either from the database of national stock exchanges and/or company websites.
ANALYSIS AND FINDINGS
Convergence to ShariAoah Principles To construct a ShariAoah compliance index, qualitative screening is first performed.
All companies with non-permissible business activities are automatically classified as ShariAoah non-compliant.
Out of the 1,362 included firms, 56 are identified as non-compliant in the qualitative screen.
All quantitative screening ratios are then computed for the remaining 1,306 firms which engage in ShariAoah-permissible business activities.
The descriptive statistics for ShariAoah indexing variables are presented in Table 6.
Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 6.
Descriptive Statistics for ShariAoah Convergence Variables GEOGRAPHY YEAR
BANGLADESH
MALAYSIA
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
DS1
DS2
IS1
IS2
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 6.
Descriptive Statistics for ShariAoah Convergence Variables (Continue.
GEOGRAPHY YEAR
MIDDLE EAST
PAKISTAN
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
DS1
DS2
IS1
IS2
Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 6.
Descriptive Statistics for ShariAoah Convergence Variables (Continue.
GEOGRAPHY YEAR TyuRKYE Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
DS1
DS2
IS1
IS2
For the remaining 1,306 non-financial companies, to apply CILOS and ENTROPY techniques a decision matrix is prepared by classifying the companies according to their geographical region for years between 2017-21.
The ENTROPY technique is then applied by following the steps mentioned in the methodology All the steps are applied and the weights are calculated.
Like the Entropy technique, the decision matrix prepared by classifying the companies according to geographical region serves as the starting point for the CILOS technique.
The subsequent steps are followed and then weights are calculated.
The IDOCRIW technique is a combination of ENTROPY and CILOS techniques.
The weights with IDOCRIW technique are computed.
The results from these steps are presented in Table 7 to Table 10.
Table 7.
Decision Matrix: Performance of ShariAoah-Compliant Firms in Five Geographies .
Tyrkiye Middle East
Bangladesh
Pakistan Malaysia
Max
Min DS1
DS2
IS1
IS2
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 8.
ENTROPY Technique Tyrkiye Middle East
Bangladesh
Pakistan Malaysia
Sum
Normalized Decision Matrix
DS1
DS2
Min Min Min IS1 Min IS2 Min IS1 Min IS2 Min DS1 Min Tyrkiye Middle East Bangladesh Pakistan Malaysia Sum Tyrkiye Middle East Bangladesh Pakistan Malaysia Average dj= .
-e.
ej= .
-d.
RANK
Share Matrix in the Sum
DS2
Min Min DS1
Min Calculation of Entropy Values DS2
IS1
Min Min Min IS2 Min Total Dj Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 9.
CILOS Technique Tyrkiye Middle East
Bangladesh
Pakistan Malaysia
SUM
Tyrkiye Middle East
Bangladesh
Pakistan Malaysia
Max
DS1
DS2
IS1
IS2
DS1
DS2
IS1
IS2
Benefit-Oriented Decision Matrix
DS1
DS2
Min Min Min IS1
Min IS2
Min Normalized Decision Matrix
DS1
DS2
Min Min Min IS1
Min IS2
Min DS1
Square Matrix R
DS2
IS1
IS2
DS1
Square Matrix P
DS2
IS1
IS2
Square Matrix F and CILOS Criterion Weights DS1
DS2
IS1
IS2
DS1
DS2
IS1
IS2
DS1
DS2
IS1
IS2
RANK The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 10.
IDOCRIW Technique a-ENTROPY b-CILOS
ai*bi IDOCRIW
DS1
DS2
IS1
IS2
SUM
The weights calculated by the CILOS and IDOCRIW techniques are very close to each other with both techniques ranking the variables equally.
The IDOCRIW technique gives the highest weight to DS1 with 29.
4% and the lowest to IS1 with The distance between the highest and lowest weights is 21.
2% within the IDOCRIW technique.
As IDOCRIW is a combination of the other two techniques, the ShariAoah ranking of 1,306 non-financial companies in the sample is performed with this technique.
Using IDOCRIW weights, the degree of ShariAoah convergence (S.
is calculated with the following equation:
Sc = 0.
300DS1 0.
213DS2 0.
200LS 0.
088IS1 0.
200IS2
The Sc value indicates the level on non-compliant activities.
therefore, the lower the Sc value, the higher the ShariAoah compliance of the company and vice Given the large sample size consisting of 1,362 companies, the results are presented by dividing the sample to seven groups and is presented in Table 11.
Table 11.
Ranking of the Sample GEOGRAPHY BANGLADESH
MALAYSIA
YEAR
0%-10%
No % Level of Non-Compliant Activities 11%-20% 21%-30% 31%-40% 41%-50% 51%-99% No % No % No % No % No % No % TOTAL Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 11.
Ranking of the Sample (Continue.
GEOGRAPHY MIDDLE EAST
PAKISTAN
TyuRKYE
TOTAL
AVERAGE
YEAR
0%-10%
No % Level of Non-Compliant Activities 11%-20% 21%-30% 31%-40% 41%-50% 51%-99% No % No % No % No % No % No % TOTAL The level of non-compliant activity is below 10% for 159 companies, 10-20% for 536 companies, and 20-30% for 404 companies.
As such, 82% of the sample has a non-compliant activity level below 30%.
In addition, 4% of the sample is completely non-compliant as they engage in non-permissible business activities.
The non-compliant activity level of the remaining 14% of the sample, is between 41 and 99%.
Looking at the percentage distribution of firms to seven groups, the difference between maximum and minimum values is below 3% for all seven groups which implies that the investment and financing policies of the companies is stable across the years.
The percentage distribution of the companies within the seven groups is stable across the time period, as the difference between maximum and minimum values does not exceed 3% for all seven groups implying that companies follow consistent and stable investment and financing policies.
To check the validity of the classification, the sample is analyzed with FTSE criteria and the results obtained are compared with IDOCRIW classification.
FTSE
is selected on purpose, as in line with this study, it employs total assets in the denominator of all ratios.
The threshold applied by FTSE is 33% for all ratios.
The comparison is reported in Table 12.
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 12.
Comparison
YEAR
IDOCRIW
Equal
Classification FTSE
0%-33%
34%-100%
As Table 12 implies the level of compliance between FTSE criteria and the categorization used in this study is above 90% for all years in the analysis.
Degree of ShariAoah Compliance and Profitability The second purpose of the analysis is to examine the relationship between corporate profitability and the degree of ShariAoah compliance.
When both net income and average equity are negative, return on equity, which is computed by taking the ratio of the net income to average equity, shows a Aufalse positiveAy result.
As such, 77 observations with false positive ROE are omitted from the analysis.
The descriptive statistics for profitability ratios, which are return on equity and return on assets and the control variable of size, are presented in Table 13.
Table 13.
Descriptive Statistics GEOGRAPHY YEAR
BANGLADESH
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
ROE
ROA
SIZESAL
Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 13.
Descriptive Statistics (Continue.
GEOGRAPHY YEAR
MALAYSIA
MIDDLE EAST
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
ROE
ROA
SIZESAL
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 13.
Descriptive Statistics (Continue.
GEOGRAPHY YEAR
PAKISTAN
TyuRKYE Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
Mean Min.
Max.
St.
ROE
ROA
SIZESAL
Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 Table 14 presents the results on the relation between degree of ShariAoah compliance and profitability as measured by ROE and ROA.
As can be seen from Table 14.
IDOCRIW is statistically significant at the 5% confidence level with a negative sign, and the size variable is statistically significant at the 1% confidence level with a positive sign when ROE is used as a measure of profitability.
However, when ROA is used, the only statistically significant variable is size.
Table 14.
ROE & ROA
MODEL
VARIABLES
IDOCRIW
ROE
3038***
1664***
6,583
1,359
ROA
9487***
1413***
6,583
1,359
SIZESAL
Constant Observations Number of no Country Ind Covid Robust standard errors in parentheses The results are still robust after controlling the industry and country dummy variables In all the specifications, the robust standard errors are reported by controlling heteroscedasticity There is no autocorrelation in the residuals (Wooldridge test Prob > F = 0.
*** p<0.
01, ** p<0.
05, * p<0.
We estimate additional regressions by omitting at least one control variables and the results are presented in Table 15.
As can be seen form Table 15 the results of all additional six equations conform with our earlier results.
Thus, at least, the results that we obtain are robust to the sets of control variables included in the model.
They imply that, while the convergence to Islamic principles has no effect on operating profitability, it has significant effect on total profitability.
Furthermore, the level of non-compliant activities is statistically significant with a negative sign, implying that as the level of convergence increases, profitability also increases as measured with return on equity.
Company size on the other hand, is a statistically significant predictor of profitability both at the operating and total profitability levels.
The Level of Convergence to ShariAoah Principles and Corporate Profitability Table 15.
Robustness MODEL
VARIABLES
IDOCRIW
SIZESAL
Constant
ROE
ROE
ROE
ROA
ROA
ROA
1204***
3337***
0730***
1300***
0094***
1211***
1179***
3199***
1634***
6282***
0932***
9480***
1384***
6,583
1,359
6,583
1,359
6,583
1,359
6,583
1,359
6,583
1,359
Observations Number of no Country Ind
Covid
0587***
6,583
1,359
Robust standard errors in parentheses The results are still robust after controlling the industry and country dummy variables In all the specifications, the robust standard errors are reported by controlling heteroscedasticity There is no autocorrelation in the residuals *** p<0.
01, ** p<0.
05, * p<0.
According to the Dupont formulation.
ROE has five components, which are interest burden, tax burden, operating profit margin, asset turnover rate, and equity multiplier.
Among these five components, the operating profit margin and asset turnover rate are the two factors that determine ROA when measured with EBIT (Stowe et al.
, 2.
According to the panel regression analysis results.
ROA measured with EBIT is not affected by the level of convergence to ShariAoah The differences in ROE are attributable to the other two factors, namely, interest burden and equity multiplier.
When analyzed together, the equity multiplier and interest burden factors imply that the high cost of debt service may offset the advantage of high leverage on profitability, which is the case for Islamic An important determinant of convergence to ShariAoah principles is low debt levels, which in markets where the cost of debt .
uoted either directly with interest rates or indirectly with higher prices applied to on account purchase.
is high, affect profitability positively.
CONCLUSION
This study constructs a ShariAoah ranking methodology for listed companies that operate in Islamic markets and to search for the relationship between corporate profitability and the level of ShariAoah compliance.
Many global financial institutions and Islamic organizations propose and apply various ShariAoah screening criteria for stocks and issuers.
However, while the aim of the mentioned criteria is to determine whether investment in a particular stock is permissible according to Islamic rules or not, they do not give any information about the level of ShariAoah Journal of Islamic Monetary Economics and Finance.
Vol.
Number 4, 2024 convergence of the issuers.
Besides, there are important differences between the ShariAoah screening techniques applied by different institutions.
Due to the important differences in the ShariAoah screening methodologies applied by various institutions, the first part of this study determines the variables to be used in the ranking by analyzing existing screening criteria applications.
Variables are then weighted using the IDOCRIW technique.
The developed ranking methodology is tested on a sample consisting of 1,362 companies that operate in 10 Islamic countries from five different geographic regions over a fiveyear period from 2017 to 2021.
The findings reveal that on average, for 82% of the sample the non-convergence level is below 30%, and between 30 and 40% for 10%.
Fifty-six companies .
% of the sampl.
are fully non-compliant as they engage in non-permissible business activities, whereas companies with non-compliance levels of 40-99% constitute only 4% of the sample.
The findings have some important practical implications.
First.
ShariAoah screening methodologies of various institutions give information to the investors whether the issuers comply with ShariAoah rules but do not give any information about the level of ShariAoah convergence.
As a result, companies that are marginally or fully ShariAoah compliant are treated equally.
With this proposed ranking and indexing methodology, more detailed data can be provided to investors with Islamic concerns.
Second, with the existence of a ranking methodology, issuers that aim to attract Islamic investors will need to formulate their business strategies more accurately.
Therefore, by providing more transparency, the ranking methodology is expected to increase competition in slamic market.
In the second part of the study, a set of panel models are estimated to identify the relationship between ShariAoah convergence level and corporate profitability.
The analysis reveals that ShariAoah compliance level is one of the determinants of return on equity, whereas it has no effect on return on assets measured as the ratio of EBIT to total assets.
The results imply that the convergence to Islamic principles has no effect on operating profitability, but it has a significant effect on total profitability.
Furthermore, the level of non-compliant activities is statistically significant with a negative sign, implying that as the level of convergence to ShariAoah principles increases, profitability as measured by return on equity increases as well.
ROA consists of two factors, operating profit margin and asset turnover rate.
The results imply that the level of convergence to ShariAoah principles does not have any significant effect on both factors, and as such has no impact on profitability at operating level.
ROE on the other hand consists of four factors which are ROA, interest burden, tax burden, and equity multiplier.
As ShariAoah convergence level has no impact on ROA, its impact on ROE is attributable to two factors, namely interest burden and equity multiplier.
Equity multiplier implies that the debt level has a positive effect on profitability.
This positive impact however is reversed if the decrease in interest burden factor offsets the increase in the equity multiplier The results of the study imply that in Islamic markets, the high cost of debt service offsets the advantage of leverage on profitability.
An important determinant of convergence to ShariAoah principles is low debt levels, which in markets where the cost of debt .
uoted either directly with interest rates or indirectly with higher prices applied to on account purchase.
is high, affecting the profitability positively.
The Level of Convergence to ShariAoah Principles and Corporate Profitability The study has important implications for practitioners and policy makers.
The existing Shari-ah compliance applications determine whether the issuers are Shari-ah compliant or not and do not give any information about the level of The methodology developed to assess Shari-ah convergence level in this study is supposed to offer a new perspective to both Islamic investors and Islamic fund managers in designing their investment strategies.
The findings about the relationship between ShariAoah convergence and profitability imply that in Islamic markets equity financing contributes positively to corporate profitability.
as such companies are better off if they rely on capital markets for financing and consequently policy makers contribute to the performance of companies if they promote capital markets.
An important contribution of the present study is that to our knowledge, the relationship between ShariAoah convergence level and corporate profitability has not been analyzed before.
as such it fills an important gap in the existing literature.
The dataset consisting of 1,362 companies from different geographical regions is another important strength of the present paper.
The dataset is available to all researchers that conduct or aim to conduct field studies in the related subject.
Due to data restrictions, the relationship between ShariAoah convergence and performance is analyzed only along the lines of profitability which is an important limitation of the study.
The relationship between ShariAoah convergence level and other corporate performance measures with comparisons to other markets is an important research topic for future studies.
To check the validity of the calculated ShariAoah screening variable weights with different multi-criteria decision-making techniques is another important research topic for future studies.
ACKNOWLEDGEMENTS
We thank to Prof.
Abdullah Yalaman for his valuable comments and to Eric Laden for his proofreading.
REFERENCES