In principle, shari’ah permits investment and trading in equities (shares of stock). However, shari’ah excludes the shares of companies that constitute significant elements of prohibition (haram elements). In practice, there are two types of shari’ah screening, literally business activity (sector screening) and financial ratio screening:

Sector screening:

The first stage in the process of shares screening is sector screening which aims to filter through the universe of investable equities so that companies whose business and activities violate shari’ah principles and injunctions are set apart and excluded. Companies whose primary business belongs to one or more of the following sectors should not be considered amongst shari’ah-compatible investment targets:

1. Conventional banking and finance (interest-based transactions and instruments).
2. Gambling, gaming, indecent entertainment, wagering, etc.
3. Conventional insurance.
4. Prohibited (non-halal) goods and commodities such as pork, non-halal meat, alcohol, tobacco, and similar stuff.
5. Weapons and ammunition.
6. Stockbroking that involves shari’ah-incompliant securities.

Financial screening:

The second stage in the screening of shares is financial ratio analysis or financial screening. Stocks that fulfill the requirements of sector screening will be subjected to financial screening to measure the significance of interest-based financing and interest income. In essence, shari’ah prohibits all forms and sources of riba. However, it tolerates, when it comes to business practice, some percentage of riba-derived income and expenses. To that end, financial ratios are used to gauge the maximum amount of interest-based items, though such ratios vary in application, depending on the index used. For example, the Dow Jones Islamic Indices employ the following set of ratios:

1. Ratio (1): Total interest-based debt/ trailing 24-month average market capitalization
2. Ratio (2): Sum of cash and interest-bearing securities/ trailing 24-month average market capitalization
3. Ratio (3): Interest bearing accounts receivable/ trailing 24-month average market capitalization

In order to end up with shari’ah-compliant shares, the three ratios must not exceed 33%. Market capitalization (market cap) refers to the total dollar amount of a company’s outstanding shares.

In addition to the above ratios, other indices (FTSE Islamic Index) applies another ratio:

interest income/ total income

For a stock to be considered shari’ah-compliant, this ratio must not exceed 5%.