Effects of Shariah-compliant business practices on long-term financial performance

Abstract

We examine the long-term effects of Shariah-compliant business practices on the financial performance of the practicing firms. Shariah is the set of personal and societal behaviors derived from study of the Qur’an, the Islamic holy book. A firm is considered Shariah-compliant when it is part of a religiously approved industry sector and meets five quantitative screens. The first three screens measure each firm’s liquidity, the fourth examines each firm’s leverage, and the final screen, as part of the “purification process,” determines if the company’s reliance upon interest-based income is at an acceptable level. We use long-term event study methodology to examine the effects of compliance over five years. We develop and test two hypotheses to determine if Shariah-compliance enhances the long-term value of the firm. Using a large sample selected from 1990 to 2018, we find that Shariah-compliance positively affects long-term financial performance as evidenced by increased values in return on assets (ROA) and return on sales (ROS). However, the practice of Shariah-compliant investing offers mixed results for stock return performance. Our results show adherence to the five quantitative Shariah screening rules could be considered as a successful long-term managerial strategy, having positive implications even for firms not in Shariah-approved industry sectors.