Debt or Equity in Islam?
Non-interest debt financing and equity financing have both been permitted in Islam. It is no surprise that there is no explicit or implicit text giving one form of financing preference over the other. Financing is part of business activity which is highly contextual and variable depending where the business is in its lifecycle. Whilst equity financing might be the only reasonable method for a start-up, an established business would generally seek debt-based financing.
It is from the beauty and comprehensive nature of Islam that no such stipulation to adopt a particular form of financing is found. If we were bound to get one type of financing only, it would put businesses into difficulty. Shariah has given us some principles with which we need to adhere to. Debt is discouraged when there is no strategy to service it. Likewise, taking on debt when it is unmanageable and beyond one's capacity to repay is also discouraged. Beyond that, it is an economic and business decision which the business can make considering what is in its best interest.
Debt vs Equity Financing – which is best for your business and why? The simple answer is that it depends. The equity versus debt decision relies on a large number of factors such as the current economic climate, the business’ existing capital structure, and the business’ life cycle stage. Some of the key factors to consider are:
- The cost of finance: Debt finance is usually cheaper than equity finance. This is because debt finance is safer from a lender’s point of view. From a conventional perspective, interest has to be paid before dividend. From a Shariah perspective, debt and profit in Shariah compliant debt-based products is paid off first. In the event of liquidation, debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors. Interest debt is also corporation tax deductible (unlike equity dividends) making it even cheaper to a taxpaying company. Arrangement costs are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs, they are also tax deductible.
- The current capital gearing of the business: Although debt is attractive due to its cheap cost, its disadvantage is that an additional return has to be paid. If too much is borrowed, then the company may not be able to meet interest and principal payments and liquidation may follow. The level of a company’s borrowings is usually measured by the capital gearing ratio (the ratio of debt finance to equity finance) and companies must ensure this does not become too high. Comparisons with other companies in the industry or with the company’s recent history are useful here.
- Security available: Many lenders will require assets to be pledged as security against loans. Good quality assets such as land and buildings provide security for borrowing - intangible assets such as capitalised research and development expenditure usually do not. In the absence of good asset security, further borrowing may not be an option.It is also possible to offer unsecured financing. Unsecured financing is Shariah compliant as long as the other principles of financing are met. To mitigate the credit risk in unsecured financing, a director can give a personal guarantee.
- Business risk: Business risk refers to the volatility of operating profit. Companies with highly volatile operating profit should avoid high levels of borrowing as they may find themselves in a position where operating profit falls and they cannot meet the interest bill. High-risk ventures are normally financed by equity finance, as there is no legal obligation to pay equity dividend.
- Operating gearing: Operating gearing refers to the proportion of a company’s operating costs that are fixed as opposed to variable. The higher the proportion of fixed costs, the higher the operating gearing. Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs remain the same, no matter the volume of sales. Thus, if sales increase, operating profit increases by a larger percentage. But if sales volume falls, operating profit falls by a larger percentage. Generally, it is a high-risk policy to combine high financial gearing with high operating gearing. High operating gearing is common in many service industries where many operating costs are fixed.
- Dilution of earnings per share (EPS): Large issues of equity could lead to the dilution of EPS if profits from new investments are not immediate. This may upset shareholders and lead to falling share prices.
- Voting control: A large issue of shares to new investors could alter the voting control of a business. If the founding owners hold over 50% of the equity, they may be reluctant to sell new shares to outside investors as their voting control at the AGM may be lost. This would make equity financing disliked for the current shareholders and debt would be preferred.
- The current state of equity markets: In a period of falling share prices many companies will be reluctant to sell new shares. They feel the price received will be too low. This will dilute the wealth of the existing owners. Note this does not apply to rights issues where shares are sold to the existing owners of the company.
These are some of the many considerations which businesses need to consider before raising equity or debt financing. This shows that the decision of debt and equity is not something set in stone from a Shariah perspective; as long as the debt-financing and equity financing are Shariah compliant, the business is at liberty to choose what is most favourable for their purpose and objective. From an investor’s perspective, they should ensure that the business is Shariah compliant and that it has passed the Shariah screening criteria. This can be ascertained by the review from a Shariah advisor.