Concept of Profit Measurement and Comparative Study of Islamic Finance

Submitted To:
Dr. Lutfullah Saqib

Submitted By:
Muhammad Mazhar Javed S-40020 Muhammad Khurram Khan S-40026

Army Public College of Management and Sciences Concept of Profit Measurement and Comparative Study of Islamic Finance

Introduction
Money is not important in life but it buy needs thats people have. Everyone wish that he/she buy everything that is comfortable in their life so for this they need money. Here are the some reason that why people have money Survival, Comfort, Happiness and Harmony. There are many sources to generate or earn the money in that sources the best way is Trade. Trade is the exchange of ownership of goods and services from one person to another person by charge fees or getting something. Trade is sometime called commerce or financial institution, where the exchange of metal, precious metal, bills and paper money. The earn money that is charge to exchange of commodity or services is called profit. Profit is the component of cost and so not the component of business. Profit defined that a business owner or enterprises think necessary to make running the business worth his while (Ildiko Orban & Tamas Sekan, 2009). In economic profit defined when revenue exceed the opportunity cost. It is standard economic assumption that every firms will achieve its maximize profit over their total cost. In general term profit, revenue or net income derived when it subtract from expenses (cost of good sold, administrative costs, selling expense, interest expense and taxes etc). Early conventional banks started in Italy and then moved in different countries of Europe, and working on credit transaction, charge money on loan and take interest. (Obaylame, 2010) It is also called interest based banking system

which takes the money from depositor and give to borrower at high interest rates. (Abdul Ghafoor Awan, 2009) The bank is the broker of money, securities and doing the roll of money exchange between lender and borrower so the earning or profit of conventional bank based on interest (Haseeb Shahid & Awais Rasoof, 2010). Interest is the most important source of income in conventional banks even though the supplementary services like money transfer; investing the money, money exchange etc is the main functions of banks. (Muhammad Hanif, 2011) Standard Bank theory that profit generate to purchase money from deposit side at low interest rate, and reselling these funds at higher interest rate from asset sides of balance sheet to borrower or lender. On the other hand conventional bank earn profit the difference between interest received from borrower and interest paid to depositor. (Muhammad Khalid, Shamsher Muhammad &Toufiq, 2007) The big question about Islamic banks that what is Islamic banking and what is the ideology of Islamic banking? Islamic banks is system which is agreement with ethos, spirits and value system of Islam and follow the governance of Islamic rule in Shariah (Keyong Pyo, Shu Zhen piao & Dowoo Nam, 2012). Islamic banks provide free interest instruments and services and also avoid from unethical and unsocial practices which is prohibited in Islam and Islamic banks ethos is to follow or lead the Islamic Shariah and prohibited from interest or riba. (Imran Ahmad & Ghulam Shabir)1 Islamic Banks perform the same intermediate function but does not receive or give interest from borrower and depositors. (Jill John2, Marwan Izzeldin) It is fees based bank system which is no pre-determined interest rate, Payment to depositors and borrower based on profit sharing. (Haseeb Shahid &
1

Islamic Banking Department State Bank of Pakistan Karachi. 2 corresponding author Address for correspondence: Department of Economics Lancaster University

Awais Raoof, 2010). An Islamic bank is indentifying itself with Shriah, Holy Quran and Sunnah as regards its operations, principles etc. Profit of Islamic banks based on trade and earning on provide of services. Money is not the commodity to exchange or not store the value. It cannot sell the money on face value. Islamic banks also depend on Musharakah and Mudarabah in which banks operate on the base of sharing loss and profits. Businessman suffers the loss and banks sharing loss or profit on the base of finance (Abdul Hameed, M. Basir, 2003). It was therefore, the verious modes of financing in addition to Mudarabah and Musharakah and Qard-e-Hasan, (Imran Ahmad & Ghulam Shbir) 1. Mudarabah (cost plus sales) 2. Bay Muajal (deffered payment sales) 3. Bay Salam (purchase with defferd delivery) 4. Bay istesna (made to order) 5. Ijarah (leasing) 6. Jualla (loan with service charges)

Above all particular modes of Islamic finance in banks which is all free interest based provided to people. Profits must be share with their depositor/investor. These six modes of financing which Islamic banks determined their profits. Measurement of profit in conventional banks there are so many ways to measure the profitability of banks. One method to measure the profit is ROE return on equity. ROE reduce the amount of profit by its equity, that owner invested in bank by purchase the stocks (William R Kitton & Lyle Matsunage, 1985). Another method is ROA return on asset gives idea that how a management using its asset to generate earning, it is dividing the annual earning by its total asset, including both financial asset and physical asset such as building and machinery etc. ROA is use for primary measurement of profitability. (Farhan Akhtar, Khizar Ali & Shama, 2011) The best feature of return on asset is that it is the ability of efficient management that utilize the asset to earn the maximum

earning, it is directly proportion of profitability of banks.. The high value of ROA shows high value of banks profit. (Sanaullah Ansari3 & Atiq Rehman) The following are the formula of both equations, ROA= Net Income/Total Asset ROE= Net Income/ SHE Banks are most complex organization, one ratio dont explain the complete information about measurement of profit, another banks are interested in to minimize the cost, profit and revenue maximize, is a drawbacks of conventional banks as compare to Islamic banks where these activities are negotiate (Jills John & Marwan Jazzeldin). Conventional banks theory that bigger the market the huge profit earns while is Islamic banks trade on capital and invests it on short term market. In Islamic banks the higher capital ratio support the banks, total loans of both side have positive relation with banks profitability, Depositor have positive relation with conventional banks and negative with Islamic banks (Abdul Ghafoor Awan, 2009). Conventional banks provide to loan Government and big companies for project financing and consumer financing at fixed and high interest rate. High interest rate means failure of business and increase in default ratios.

Literature Review
The literature of Islamic banking profitability is rapidly expanding and interesting topic of Muslims researchers. In this section we review the some of leading research on Islamic and conventional banks. Review of Islamic banking profitability Abdul Ghafoor (2009) determined the external profitability of Islamic banks, argued that conventional banks theory that bigger the market increase the profit of banks, but this theory is opposite of Islamic banks, Islamic banks utilize the capital and invest in short term financing. Islamic banks are better management in competitive market as compare to monopolistic markets, conventional banks are better perform in monopolistic markets involve them

Shaheed Zulfikar Ali Bhutto Institute of Science & Technology (SZABIST), Islamabad, Pakistan

moral hazard problem and adverse selection. Which is the reason of high default and less profitabilty? Bashir and Hassan (2004) covering the every points of deterring the profitability of Islamic banks. Bashir (2000), Bashir and Hassan (2004) determined the profitability of Islamic banks in 1994 to 2001, they studied that Islamic banks have better capital asset ratio as compare to conventional banks, which means have better capitalized. Abdul Ghafoor (2009) Islamic banks use non-interest margin (NIM) which is the bank fees or non-interest income, service charges or foreign service charges are determined the profitability of banks. Alkassim (2005) find that higher capital ratios are positive relation with profitability of both banks. Total loans have positive relation with profitability of both banks. So if deposit ratios increase that is benefit for conventional banks but negative relation with Islamic banks. Ferhan, Khizer & Shama (2011) stated that in conventional banks the asset management and efficiency has positive relation with profit of banks. If banks utilize their asset with appropriate management it has inversely proportion to ROA so leverage of asset decrease and ROA increase witch increase the profit of banks.

Profit Measurement in Conventional Banks Banks that supervise and examine the use of ROA and ROE, to know how industries and markets are working (Gilbert & Wheelock). In USA, there was adverse result in banking sector because of diseconomies of scale, because the link between the size and capital ratio is very important. Assets management and operating efficiency are favorable and unfavorable to profit. (Akhtar, Ali &

Sadaqat; 2011). In this research paper there are two methods that use for measure the profit of conventional banks. M-1 Return on Asset tells that how much a bank is organized to utilize

its assets. That is also used to compare with other same size banks. Return on Asset if higher is better for bank. Return on Asset = M-2 Net Income + Interest Expense/Average Asset

Return on Equity tells us the internal performance of the

shareholders and measure it. There are some points which are as follows. It tells the return of the shareholders investment. It tells, what outsiders are thinking It compares of same size of banks, and how these banks are performing.

Return on Equity =

Net Income/ Average total equity

Among these two methods i.e. Return on asset and Return on Equity, Return on Equity in best. Bank needs to consider on efficiency, asset quality and capital adequacy to know how bank is fulfilling its job and it is also consider to be shock absorber (How to measure Bank performance September; 2010). To calculate ROE by asset by subtracting liabilities. That tells the real picture of a firm. By this, bank come to know, how much a bank offer loan to company and whether that company in position to give it back or compare with other companies. ROE also help to measure the stock a company is offering and how that company is managing. ROE also tells, how management is performing in that firm, and if efficient management than that will increase ROE. Musharakah is sharing of profit and loss among partners. Islamic banks can also apply the same method by generating new business according to shariah law on base of musharakah. This can prosper our country Pakistan. (Islamic finance: The regulatory challenge by Rifaat Ahmed Addel Karim, Simon)

Type of monetary project by 1. Manufacturing In musharakah, purchasing house or any project on lease or by installment. 2. Trade Both on musharakah and mudarabah 3. Serving Service charges can also be deducted by bank, its allowed in Islamic shariah law. (Islamic Banking in Islamic Republic of Iran and Pakistan by Zubair Iqbal, Abbas Mirakhor) According to musharakah, physical investment is also must and profit/loss distributed is also depend on physical investment. But in contrast to commercial banks, when they give loan for a project, which do not depend on profit/ loss of project, they just have concern with interest. (An Introduction to Islamic Finance: Theory and Practice by Zamir Iqbal, Abbas Mirakhor) In musharakah the Islamic bank, when investing in export and import by bank and customer, the profit/loss is shared on agreed agreement after goods are sold. (Islamic Commerical law by Muhammad Yusuf Saleem)