How Shariah Screening Works: A Step-by-Step Guide

The complete process for determining whether a company is Shariah compliant — from sector exclusion to financial ratio testing.

The Two-Stage Screening Process

Shariah screening for equities happens in two stages: qualitative (sector) screening and quantitative (financial ratio) screening.

Stage 1: Sector Screening

The first screen removes companies whose primary business activity is prohibited under Islamic law:

Conventional finance — banks, insurance companies, mortgage lenders

Alcohol — production, distribution, or significant retail sale

Tobacco — production or distribution

Pork — production or significant sale

Weapons — controversial weapons manufacturers

Adult entertainment — including online content

Gambling — casinos, sports betting, online gambling platforms

A company involved in any of these activities as its primary business is excluded regardless of its financial ratios.

Stage 2: Financial Ratio Screening

Companies that pass the sector screen are then tested against financial ratios:

Debt Ratio

AAOIFI standard: Total Debt ÷ 24-month Average Market Cap < 33%

Companies with excessive leverage are excluded because debt in Islamic finance is treated as a liability, and high debt often involves riba (interest)

Revenue Purity

Non-compliant revenue as a % of total revenue must be below a threshold (typically 5%)

This catches companies with permissible primary businesses but significant non-compliant revenue streams (e.g., a retailer with a financial services arm)

Stage 3: Purification

For companies that pass but have minor incidental non-compliant revenue, investors are required to purify their returns:

*Purification = (Non-compliant Revenue ÷ Total Revenue) × Dividend Received*

This amount is donated to charity. ETFs report a quarterly purification ratio to help investors calculate their obligation.

Contents

The Two-Stage Screening Process Stage 1: Sector Screening Stage 2: Financial Ratio Screening Stage 3: Purification