Islamic Modes of Financing

Mudaraba
Problems and Solutions
 Summary of the Previous Lecture
In previous lecture we studied the following concepts of
Mudaraba financing;
1. Features of Mudaraba
1.Nature of the contract
2.Capital
3.Management of the Mudaraba
4.Profit and loss sharing mechanism
2. Termination of Mudaraba
3. Collective Mudaraba
3. Running Mudaraba
 Learning outcomes
You will be able to understand some practical situations
and their solutions.
 Definition
• This is a kind of partnership between the two parties
where one partner contributes capital and the other one
contributes efforts as manager or entrepreneur. The
profit of the venture is share at an agreed ratio while the
losses are borne by the capital provider.

• The investment comes from “Rabb-ul-Maal” (Investor)

while the management and work is an exclusive
responsibility of the working partner, who is called
Mudarib.
Features of Mudaraba Contract
There are number of principles governing the
Mudaraba contract, e.g.

1. Nature of the contract

2. Capital

3. Management of the Mudaraba

4. Profit and loss sharing mechanism

1. Nature of the Mudaraba Contract

• Generally Mudaraba contract allows anyone of the

contracting parties to terminate the contract unilaterally.

• However, the contract shall not be terminated unilaterally

if the manager has commenced the work or when both

parties have agreed not to terminate the contract during

a specified time.
 2. Capital

• The capital shall be contributed by the capital

provider and shall be managed by the manager

to generate income.

• The capital of Mudarabah may be in the foRM of

monetary or non-monetary assets.

 2. Capital
• Monetary assets of different currencies shall be valued according
to an agreed currency at the time of signing the Mudarabah
contract.

Illustration: Multi Currency Mudarabah Fund

An Islamic Financial Institution has launched a global Mudarabah

fund. The fund accepts investment in various currencies such as
USD, Euro, Ringgit Malaysia, Saudi Riyal etc. However, the
prospectus has stated that the Mudarabah fund is denominated in
USD. Hence, all contributions by investors in non-USD currencies
will be converted into USD equivalent amount based on the
exchange rate on the day of subscription to the Mudarabah fund.
 2. Capital
• The mutually agreed currency shall be
applicable throughout the Mudarabah business
venture. For example, any capital investments
after the initial investment shall be converted into
the currency mentioned in the prospectus.
 2. Capital
• Capital in the form of non-monetary assets which may
include intangible assets shall be valued based on the
valuation determined by a third party or as agreed upon
by the contracting parties at the time of contract.

• Non-monetary Mudarabah capital contributed may be

redeemed at its original value invested should it be
possible or otherwise at its residual market value upon
termination or the expiry of the contract.
 2. Capital
Illustration: Non Monetary Mudarabah Capital Contribution

A public transportation company, XYZ applied for

Mudarabah-based financing from an Islamic Bank. The bank
agrees to provide five buses to the company as Mudarabah
capital valued at Rs.10 million based on prevailing market
value and the company should manage the operations of
these buses. Upon termination of the contract the Murabaha
capital may be valued at its original value or the residual
market value as agreed in the contract.
 2. Capital
• Debts such as account receivables or loans due to a
capital provider do not qualify as capital of Mudarabah.

• The agreed capital shall be made available to the

manager to commence the business activities.

• The capital may be fully or partially disbursed or made

available to the manager at the time of the contract or
based on terms of the contract.

• Capital provider and manager may agree for a gradual

withdrawal of Mudarabah capital by the capital provider.
 2. Capital
• Failure to provide capital by the capital provider as per
the agreed schedule shall constitute a breach of promise
according to specified terms and conditions of the
contract.

• The manager has an option to terminate the agreement

or both parties may agree to revise the agreement based
on actual capital contribution.
 2. Capital
• Where the agreement is terminated the manager
has to return the outstanding capital (if any). If
the Mudarabah expenditure exceeds the actual
capital contribution, such liability shall be borne
by the capital provider up to the limit of the total
amount committed under the contract.
 2. Capital

• Upon liquidation or maturity of the Mudarabah contract,

all outstanding capital shall be returned to the capital

provider.

• Any outstanding capital including the share of profit shall

be deemed as debt due to the capital provider.

• The manager shall not guarantee the Mudarabah capital.

 2. Capital
• The capital provider may require the manager to arrange

for an independent third party performance guarantee.

• The guarantee shall be executed as a separate contract

and be utilized to cover for any loss or depletion of

capital in the event of misconduct, negligence,

dishonesty, fraud or breach of the terms of the contract

by the manager.
 3. Management of the Mudaraba
• Mudarabah capital will be used only for the Sharia
compliant activities.

• Manger/Mudarib will have the exclusive rights to manage

the contract. However, the capital provider has the right
to information regarding the conduct of the business and
manger.

• Manager shall not be liable for any loss of capital unless

it is due to any negligence, dishonesty, misconduct or
breach of contract.
 3. Management of the Mudaraba
Restricted Mudaraba
The powers of the manger shall be provided under the
terms and conditions of the contract.
•The contract may restrict the manager’s role/functions
such as
•determination of location,
•period for investment,
•type of project and
•commingling of funds,
provided it does not nullify the purpose/objective of the
contract. However, the restrictions shall not unduly
constrain the manager.
 3. Management of the Mudaraba
Unrestricted Mudarabah
Rabb-ul-mal gives full freedom to Mudarib to
undertake whatever business he/she deems fit,
this is called unrestricted Mudarabah. There are no
limits and conditions specified and the manager
has the discretion to use the capital in the best
interest of the Mudaraba.
However, Mudarib is not authorized to:
•Keep another Mudarib or a partner
•Mix his own investment in that particular
Mudaraba without the consent of Rabb-ul Mal.
 3. Management of the Mudaraba
Single tiered Mudaraba
•A Mudarabah contract shall require the manager to deploy
the capital to a profitable venture. The manager shall be
personally responsible to ensure the proper management
of the capital is in the interest of the capital provider.

Multi-tiered Mudaraba
•The manager of a Mudarabah contract may assign the
capital to another manager in another Mudarabah contract
with the consent of the primary capital provider.
 Multi-Tiered Mudarabah
Illustration: Multi-Tiered Mudarabah
• A Mudarabah capital fund subscribed by investors specified
that the fund is to be proportionately invested: 30% in
Shariah approved equities, 30% in Sukuk and 40% in real
estate properties. The fund manager allocates the fund
according to the three sectors and engaged three managers,
each specialized in the different sectors to manage the three
separate funds. The performance of each fund is shared
between the manager of each fund and the fund manager.
The fund manager will then share the portfolio performance
of the Mudarabah fund with the investors.
 4. Distribution of Profit & Loss
1. It is necessary for the validity of Mudarabah that the
parties agree right at the beginning on a definite
proportion of the actual profit to which each one of them is
entitled.
2. They can share the profit at any ratio they agree upon.
3. However in case the parties have entered into Mudarabah
without mentioning the exact proportions of the profit, it
will be presumed that they will share the profit in equal
ratios.
4. Some incentives my be given to the Mudarib.
 4. Distribution of Profit & Loss
5. Apart from the agreed proportion of the profit, the
Mudarib cannot claim any periodical salary or a fee or
remuneration for the work done by him for the
Mudarabah.

6. The Mudarib & Rabb-ul-Maal cannot allocate a lump

sum amount of profit for any party nor can they
determine the share of any party at a specific rate tied
up with the capital.
 Termination of Mudarabah
1. Mudarabah can be terminated any time by either of the
two parties by giving notice.

2. If Mudarabah was for a particular time period, it will

terminate at the end of the term..

3. Termination of Mudarabah means that the Mudarib

cannot purchase new goods for the Mudarabah.
However, he may sell the existing goods that were
purchased before termination.
 Collective Mudarabah
1. Collective Mudarabah means a joint pool created
by many investors and handed over to a single
Mudarib who is normally a juristic person.
2. Collective Mudarabah creates two different
relationships:
a. Relationship between investors themselves, which
is Shirkah or Partnership.
b. Relationship of all the investors with Mudarib,
which is Mudaraba.
 Running Mudarabah
1. Investors come in and go out at different dates

2. Profits are calculated on daily basis.

3. Redemption before maturity

a. If the assets of Mudaraba are in illiquid form an

investor may redeem his share by selling it to the
pool..

b. If the assets are in liquid form a provisional

amount may be given to him subject to final
settlement
 Illustration: Lump sum profit
share in Mudarabah venture
A Mudarabah agreement begins with a simple profit
sharing ratio of 50:50. The capital provider further specifies
that should the venture achieve a target profit above
Rs.100,000, the capital provider will keep the first
Rs.100,000 with the balance to be given to the manager.
During the contract period, if the profit is Rs. 80,000 the
profit share to the manager and capital provider each is Rs.
40,000. If the profit is Rs. 150,000, the profit share of the
manager is Rs.50,000 and the profit to the capital provider
is Rs.100,000.
Illustration: Tiered Profit Sharing
Ratio- Case A
XYZ Co. entered into a Mudarabah agreement valued at
Rs.1 million of Mudarabah capital with ABC Bank at an
agreed profit sharing of 40:60.
(Case A)
In addition, as an incentive for XYZ Co. The manager, ABC
Bank stated that if XYZ Co. could manage to generate a
return of more than 15%, then the excess of profit would be
allocated solely to XYZ Co.. At the end of the year, XYZ
Co. managed to generate a return of 21% (Rs.210, 000).
Hence, the distribution of profit will be as follows:
Profit subject to profit-sharing ratio:
15/21 x Rs.210, 000 = Rs.150, 000
XYZ Co. : 0.4 x Rs.150, 000 + The profit
exceeding 15% return.
: Rs. 60, 000 + (Rs.210,000-150, 000)
: Rs.60, 000 + Rs.60, 000
: Rs.120, 000
ABC Bank : 0.6 x Rs.150, 000
: Rs.90, 000
 Tiered Profit Sharing Ratio-
Case B
In addition, ABC Bank stipulated that if XYZ Co. could
manage to generate a return of more than 15%, then
Rs.10,000 of the excess profits would be for ABC Bank and
the remaining for XYZ Co. At the end of the year, XYZ Co.
managed to obtain a return of 21% (Rs.210,000). Hence,
the distribution of profit as follows:
Profit subject to profit-sharing ratio:

15/21 x Rs.210, 000= Rs.150, 000

ABC Bank : 0.6 x Rs.150, 000 + Rs.10, 000 of the
profit exceeding 15% return.
: Rs.90, 000 + Rs.10, 000
: Rs.100, 000

XYZ Co. : 0.4 x Rs.150, 000.00 + The balance

of profit exceeding 15% return.
: Rs. 60, 000 + (Rs.60,000 - Rs.10,000)
: Rs.60, 000 + Rs.50, 000
: Rs.110, 000
 Profit Sharing Arrangement
Based on Performance
A Mudarabah fund is launched for investments in a portfolio
of shares, Sukuk and property investments. On average
15% to 20% return per annum is expected from such
investments. The fund declared a profit sharing ratio of 90:
10 between the investors and the fund manager if the yield
is 20% or less for one year investment period. The ratio
increases in favor of the manager to 80:20 if the yield
exceeds 20% for the same period. The fund size is Rs.100
million.
Scenario 1
If the total expected yield is 20%, how much total profit is
shared with the investors?
The total profit distribution to investors should be 0.9 X
Rs.20 million = Rs.18 million.

Scenario 2
If the total expected yield is 40%, how much profit is earned
by the manager?
The total profit payout to manager is 0.2 X 40 million = Rs.8
million
 Profit Sharing Arrangement
Based on Investment Tenure
A Mudarabah venture is set up between three capital
providers and a venture manager who is tasked to manage
the business. The venture begins with a profit sharing
arrangement of 70:30 for the first three years, where the
manager will receive 30% of the net profits. Should the
venture remains viable thereafter, the profit sharing ratio
shall revert to a 60:40 arrangement.
 Profit Determination for the Period,
Upon Sales of Equity Claims and
Dissolution
A Mudarabah investment fund valued at Rs.100 million declared 80:20
profit sharing ratio between the investors and the manager.
Scenario 1
If the investment declares profit on a periodic basis and reported a total
fund yield of 10%, investors profit share is Rs. 8 million for the year.
Scenario 2
If at the end of year 2 based on the net asset value of the investment,
fund is sold to third party for Rs.120 million, investors’ share of the gain
in disposal of investment is Rs. 16 million.
Scenario 3
Upon maturity of the investment period, the net asset value of the
investment is Rs. 150 million, the investors’ share of the net proceeds
of the dissolution includes Rs. 40 million profit in addition to the refund
of capital or Rs.100 million.
 Profit Distribution Arrangement on
A Multi-Tiered Mudarabah Venture
A one year restricted Mudarabah fund of Rs.500,000 with a
profit sharing ratio of 80:20 between the investor and the
Islamic financial institution is established for project
financing. With the fund the Islamic financial institution
provides one year project financing based on Mudarabah
with an agreed profit sharing ratio of 70: 30 between the IFI
and the customer. At the end of the year a profit of
Rs.300,000 is recorded from the project. The profit is
distributed as follows:
Rs
 Loss Adjustment
Scenario A
After the conclusion of the Mudarabah contract, part of the

inventory purchased with Mudarabah financing was

destroyed by flood. The partners assessed that the

damage by flood amounted to 40% of capital impairment.

The immediate loss is borne by the capital provider and the

financing arrangement was terminated.

 Loss Adjustment
Scenario B
During the period of Mudarabah financing, capital
employed to finance the business resulted in 10% loss of
capital at the end of one reporting period. Both partners
agree that the reported loss is carried forward to the next
period which subsequently reported 40% return on original
capital. At the end of the financing period, 30% return on
capital is distributable between the partners.
 Loss Adjustment
Scenario C
A business is financed using a Mudarabah financing

facility. The business reported 30% profit over its capital in

the previous reporting period. In the current reporting

period, the business resulted in 10% loss of capital. Both

partners agree that the reported loss is set-off against the

previous reported period profit.

 Termination of Mudarabah
Contract
Mudarabah financing for a period of two years provided by an IFI
to the customer is reviewed quarterly in terms of the manager’s
compliance and performance of the funds. In the third quarter of
the 1st year it was found that the performance of the fund
exceeds expectation and additional financing was granted. Profit
was distributed at the end of the first year and the approved
capital remains outstanding in the second year. In the second
quarter of the second year, the manager activities failed to
observe the scope of the financing requirement and thus violated
the conditions specified in the contract. The customer appealed
to ratify and the financing period continued. However in the third
quarter capital is impaired as 50% of the fund is lost. As a result
the contract is voidable and IFI has the right to rescind the
contract and held the manager liable for any loss due to the
violation of the contract.
 Summary of the Lecture
We studied the Mudarabah contract under some
supposed situations to further clarify the concept.