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Mudarabah & Musharakah

Submitted By:

Tanveer Ahmad
Exam# 394
MBA (B/F) Final

Submitted To:

Prof: Sir Aman Ullah Sahib

Deptt: of Business Administration

Gomal University
Dera Ismail Khan
0 Table Of Contents

S.N Page
o #
1 Introduction 1

2 Prohibited Elements 1

3 Mudarabah Financing 2

4 Basic Tenets of Mudarabah Contract 2

5 Types of Mudarabah Contract 3

6 Termination of Mudarabah 4

7 Musharakah Financing 5

8 Forms of Musharakah 5

9 Permanent Musharakah 5

10 Diminishing Musharakah 6

11 Basic Tenents of Musharakah 6

12 Profit Share in Musharakah 7

13 Sharing of Loss 7

14 Termination of Musharakah Contract 8

15 Conclusion on Both modes 9

16 Benefit on Society 9
Mudarabah and Musharakah

The Financial markets and the financial industry are witnessing the growth
of Islamic banking and finance. Although an Islamic banking and finance is
a relatively new force in the world of banking but it surely is a force to
reckon with. Especially after the recent financial doom which slumped
markets world-wide and triggered the global financial crisis.
Islamic financial institutions have demonstrated significant resilience and
have been less affected compared to the conventional financial institutions
because of the prohibitions on excessive leverage. The growth, in both size
and in diversity in the Islamic finance industry has been especially robust
over the past few years.
It is today a USD 1 trillion industry and is growing at a phenomenal pace of
15 percent annually. Apart from its traditional strong hold in the Middle
Eastern countries, it has spread its wings to Western countries as well.
Islamic finance has a significant presence in Europe and England is touted
to be the Islamic finance hub of the western world. Many leading and
popular international banks have established Islamic banking ‘units’ or
‘windows’ to provide financial services and products that conform to
There are various modes of financing in Islamic finance and Mudharabah
and Musharakah fall within this ambit. They are essential modes of
financing and are very widely used by Islamic banking and financial
institutions. It goes without saying that all the modes of financing adhere
to Shariah principles.
The 4 basic elements prohibited in Islamic mode of financing are

• Riba (Interest),
• Haram (Forbidden or impermissible goods),
• Maysir (Gambling)
• Gharar (Ambiguity)
Mudarabah financing:

The term refers to a form of business contract in which one party brings
capital and the other personal effort. The proportionate share in profit is
determined by mutual agreement. But the loss, if any, is borne only by the
owner of the capital, in which case the entrepreneur gets nothing for his
The financier is known as ‘rab-al-maal’ and the entrepreneur as M
‘ udarib’.
As a financing technique adopted by Islamic banks, it is a contract in which
all the capital is provided by the Islamic bank while the business is
managed by the other party.
The profit is shared in pre-agreed ratios, and loss, if any, unless caused by
negligence or violation of terms of the contract by the ‘mudarib’, is borne
by the Islamic bank. The profits in a Mudarabah agreement may be shared
in any proportion agreed between the parties beforehand. However, the
loss is to be completely borne by the owner of the capital.
In case of loss, the capital owner shall bear the monetary loss and
entrepreneur shall loose the reward of his effort. Mudarabah could be
individual effort or a joint one. Islamic banks practice Mudarabah in both its
forms. In case of individual Mudarabah, an Islamic bank provides finance to
a commercial venture, run by a person or a company on the basis of profit
The joint Mudarabah may be between the investors and the bank on a
continuing basis whereby the investors keep their funds in a special fund
and share the profits. Many Islamic funds operate on the basis of joint

The basic tenets of a Mudarabah contract are:

• There are two contracting parties to a Mudarabah financing, i.e. the

provider of funds (rab-al-maal) and the entrepreneur (Mudarib). The
latter does not contribute any form of capital.
• Profit is shared between the capital provider and the entrepreneur
according to a pre-determined profit-sharing ratio. The profit-sharing
ratio has to be mutually consented upon and explicitly stated at the
time of contracting (aqad or agreement) and has to be a
proportion/percentage of profits.
• Financial loss under Mudarabah financing must be borne by the
Islamic banking institution. However, if the loss is caused by
negligence, mis-management or breach of contracted terms by the
customer, then the customer is liable for the loss.

Mudarabah financing can be divided into two main types, i.e.

1. Restricted Mudarabah (Mudarabah al muqayyadah)

2. Unrestricted Mudarabah (Mudarabah Mutlaqah)

Under restricted Mudarabah, the Islamic banking institution may specify

certain terms and conditions, for example stipulate a particular business or
particular place for the customer to invest the capital. The customer is
bound by all these restrictions and any violation of these restrictions may
make the customer liable for the loss, if any.
This type of Mudarabah financing may be used for contract financing of a
specific project awarded to the customer.
Under unrestricted Mudarabah, an Islamic banking institution does not
impose any limitation on the customer/ partner, for example, on the type
of business, place of business, methods of payment from the customers
and period of investment.
In this case, the Islamic banking institution will not have any recourse to
the customer should the business incur losses due to the investment policy
as there would have been no such policy prescribed by the Islamic banking
institution in the first place. This type of Mudarabah, for example, may be
used towards financing a customer’s working capital requirements.
The most important element of the Mudarabah contract is the
“distribution of profit”.
At the inception of the Mudarabah contract the contracting parties should
agree on a definite proportion of the actual profit to which each of them is
No particular proportion has been prescribed by the shariah; rather, it has
been left to their mutual consent. They can share the profit in equal
proportions, and they can also allocate different proportions for the rab-al-
maal and the mudarib.
However, they 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.
To cite an example, let’s say the rab-al-mal provides a capital of Rs
800,000. On this capital they cannot agree on a condition that Rs 60,000
out of the profit, if any, shall be the share of the mudarib, nor can they say
that 15 percent or more of the capital shall be given to rab-al-maal.
However, what can be agreed upon according to shariah is the profit-
sharing ratio. Example, any profit arising out of the business, i.e. 40
percent of the actual profit shall go to the mudarib and 60 percent to the
rab-al-maal or vice versa.
It is also allowed that different proportions of profit are agreed in different
situations. For example, the rab-al-maal may say to the mudarib at the
beginning of the aqad that if ‘you trade in gold, you will get 50 percent of
the profit and if you trade in silver, you will get 33 percent of the profit, the
profit-sharing ratio can be anything in these circumstances as agreed upon
by the contracting parties.
Similarly there can be a case where the rab-al-maal can say to the mudarib
that if he does business in his city or town, he can be entitled to 30 percent
of the profit, and if he does it in another town, his share can be 50 percent
of the profit. It is important to cite, that apart from the agreed proportion of
the profit, as determined in the above manner, the mudarib cannot claim
any periodical salary or a fee or remuneration for the work done during the
Mudarabah contract.
On the other hand, if the business has incurred loss in some transactions
and has gained profit in some others, the profit shall be used to offset the
loss at the first instance then the remainder, if any, shall be distributed
between the parties according to the agreed ratio.
Termination of Mudarabah contract:
The contract of the Mudarabah can be terminated at any time by either of
the two parties. The only condition is to give a notice to the other party. If
all assets are in cash form at the time of termination, and some profit has
been earned on the principle amount, it shall be distributed between the
parties according to the agreed ratio.
However, if the assets are not in the cash form, the mudarib shall be given
an opportunity to sell or liquidate them, so that the actual profit may be
determined. There is a difference of opinion among the Muslim jurists
about the question whether the contract of Mudarabah can be in effect for
a specified period after which it terminates automatically.
However, this difference of opinion relates only to the maximum time limit
of the Mudharabah. On the question whether minimum time limit can be
fixed by the parties before which Mudarabah cannot be terminated? No
express answer to this question is found in the books of the Islamic Fiqh,
but it appears from the general principles that no such limit can be fixed,
and each party is at liberty to terminate the contract whenever he wishes.
Therefore, if the parties agree, when entering into the Mudarabah, that no
party shall terminate it during a specified period, except in specified
circumstances it does not seem to violate any principle of shariah,
particularly in the light of the famous hadith which says:
“All the conditions agreed upon by the Muslims are upheld, except a
condition which allows what is prohibited or prohibits what is lawful.”
Musharakah financing:

Musharakah is another popular technique of financing used by Islamic

banks. It could roughly be translated as partnership. In this technique two
or more financiers provide finance for a project. All partners are entitled to
a share in the profits resulting from the project in a ratio which is mutually
agreed upon. However, the losses, if any, are to be shared exactly in the
proportion of capital proportion. All partners have a right to participate in
the management of the project.
However, the partners also have a right to waive the right of participation
in favour of any specific partner or person. This equity financing
arrangement is widely regarded as the purest form of Islamic financing.

There are two main forms of Musharakah:

• Permanent Musharakah
• Diminishing Musharakah

Permanent Musharakah:

In this form of Musharakah an Islamic bank participates in the equity of a

project and receives a share of profit on a pro-rata basis. The period of
contract is not specified. So it can continue so long as the parties
concerned wish it to continue. This technique is suitable for financing
projects of a longer life where funds are committed over a long period and
gestation period of the project may also be long.

Diminishing Musharakah:

In this form of Musharakah equity participation and sharing of profit on a

pro-rata basis is allowed. It also includes a method by which the bank
keeps on reducing its equity in the project and ultimately transfers the
ownership of the asset to the participants.
The contract provides for a payment over and above the bank share in the
profit for the equity of the project held by the bank. That is the bank gets a
dividend on its equity. At the same time the entrepreneur purchases some
of its equity. Thus, the equity held by the bank is progressively reduced.
After a certain time the equity held by the bank shall come to zero and it
shall cease to be a partner.
Musharakah form of financing is being increasingly used the Islamic banks
to finance domestic trade, imports and to issue letters of credit. It could
also be applied in agriculture and industry.
The basic tenets of a Musharakah contract

• Both parties contribute a portion of capital which may not necessarily

be equal. The contributed capital can be either in the form of cash or
assets with an ascribed value.
• While both partners may undertake the management of the
business, if a partner chooses to withdraw from the management to
become a sleeping partner, such arrangement is allowed. The
partner is also allowed to appoint a third party to manage the
business on behalf of the Musharakah partnership.
• The project or business must be permissible by shariah. The
proportion of profit to be distributed between the partners must be
mutually pre-agreed upon inception of the contract.
• Any losses shall be distributed between the partners according to the
capital contribution ratio. However, if the loss is due to the
negligence of the managing partner or management team, such
losses shall be borne by the respective partner or the management

Distribution of profit in Musharakah:

The distribution of profit is a very crucial issue in a Musharakah contract.

The proportion of profit to be distributed between the partners must be
agreed upon at the time of inception of the contract. If there’s no mention
of the proportion of profit then the contract is not valid according to
shariah point of view.
This is because the ratio of profit for each of the partner must be
determined in proportion to the actual profit accrued to the business, and
not in proportion to the capital invested by him. Also, it is not allowed to fix
a lump sum amount for any one of the contracting partners, or any rate of
profit tied up with his investment.
Let us take an example to explain the distribution of profit in light of the
Musharakah contract. Suppose, A and B enter in to a partnership and it is
agreed between them that A shall be given Rs 20,000 per month as his
share in the profit, and the remaining profit will go to B, this kind of
partnership will be rejected by shariah. Similarly, if they agree between
them that ‘A’ will ge20 percent of his investment, the contract will still be
pronounced as invalid by shariah.
According to shariah, the correct basis for the distribution of profit would
be an agreed percentage of the actual profit accrued to the business. If a
lump sum amount or a certain percentage of the investment has been
agreed for any of the partners, it must be expressly mentioned in the aqad
(agreement) that it will be subject to the final settlement at the end of the
term, meaning thereby that any amount so drawn by any partner shall be
treated as ‘on account payment’ and it will later on be adjusted to the
actual profit he may deserve at the end of the term. But in case if no profit
is actually earned or is less than anticipated, the amount drawn by the
partner shall have to be returned.

Sharing of losses:

The sharing of losses is done in proportion to the investment made by each

contracting partner in the venture. For example, if a partner has invested
30 percent of the capital, he must suffer 30 percent of the loss, not more,
not less, and any condition to the contrary shall render the contract invalid.
According to Muslim scholars the ratio of the share of a partner in profit-
loss both must conform to the ratio of his investment. But some scholars
differ on this profit-loss ratio of investment. Some scholars assert that the
ratio of the profit may differ from the ratio of investment according to the
agreement of the partners, but the loss must be divided between them
exactly in accordance with the ratio of capital invested by each one of
It is this principle that has been mentioned in the famous maxim: ‘profit is
based on the agreement of the parties, but loss is always subject to the
ratio of investment.

Termination of Musharakah contract

: A Musharakah contract can be terminated in case of following events

• Every partner in the Musharakah contract has the right to terminate

the contract at anytime, provided the partner gives his other
partner/partner’s notice to this effect, upon which the contract will
come to an end.
In this case, if the assets of the Musharakah contract are in cash
form, all of them will be distributed at pro-rata basis between the
partners. But if the assets are not liquidated, then the partners to the
contract may agree either on the liquidation of the assets, or on their
distribution or partition between the partners, as the case may be. In
case of dispute between the partners in the matter where one of the
partner seeks liquidation while the other wants the partition or
distribution of the non-liquid assets themselves, the latter shall be
preferred, because after the termination of Musharakah, all the
assets are in joint ownership of the partners, and a co-owner has a
right to seek partition or separation, and no one can compel him on
liquidation. However, if the assets are such that they cannot be
separated or partitioned, i.e. Machinery, then they shall be sold and
the sale proceeds shall be distributed.
• If any one of the partners dies during the contract, the contract of
Musharakah with him stands terminated. His heirs in this case, will
have the option either to draw the share of the deceased from the
business, or to continue with the contract of the Musharakah.
• If any one of the partners becomes insane or otherwise becomes
incapable of effecting commercial transactions, the Musharakah
stands terminated.
• If one of the partners wants termination of the Musharakah, while the
other partner or partners like to continue with the business, this
purpose can be achieved by mutual agreement. In this case, the
partners who want to run the business may purchase the share of
the partner who wants to terminate his partnership, because the
termination of the Musharakah with one partner does not imply its
termination between other partners.
Conclusion on Mudarabah and Musharakah Financing:
Financing through Mudarabah and Musharakah does never mean the
advancing of money.
In Mudarabah it means to participate in the business and in the case of
Musharakah it means
sharing in the assets of the business to the extent of the ratio of financing.
An investor/financier must share the loss incurred by the business to the
extent of financing. The partners have the liberty to determine, with
mutual consent, the ratio of profit allocated to each one of them, which
may differ from the ratio of investment. However, in case a partner has
expressly excluded himself from the responsibility of work for the business,
he cannot claim more than the ratio of his investment in the project or
business venture. In case of loss suffered in the project each partner must
bear the loss exactly in the proportion of his investment.

Benefits of Mudarabah/Musharakah financing on society:

Both Mudarabah/Musharakah financing are a part of the Islamic financial

system which rejects the concept that a borrower is liable for the
repayment of the funds borrowed and a predetermined return on those
funds, regardless of the performance of the borrower’s business. Under the
Islamic system, this rejection of interest is replaced with the concept that
the lender is to assume the risks of the borrower’s business and share in
the profits and losses of that business. Interest or riba at the outset is
strictly prohibited in both Mudarabah/Musharakah or in any mode of
Islamic financing.
This is because interest as human suffering has shown over centuries,
causes much harm to human beings. Its institutionalization, as in the
secular/ western economies, causes wealth to be concentrated within the
hands of the few, which is something Islam clearly forbids.
Mudharabah/Musharakah financing are both based upon equity and profit-
sharing This is due to the Islamic financial system which views equity
capital, which is productive in a real sense and the social and economic
relationships that have to be built, are not based on debt relationships, but
upon equity and participation.
Now this is a very different concept of society from that of the
contemporary capitalist society, which is a society where human beings
groan under the burden of debt, and the individual is seen as a consumer.
Islam says it has to be a participating, a profit-sharing society, based on a
different model, and in this model, freedom can be ensured because every
individual feels he is a participant in the drama of production and not in
any way subject to a debt situation. Islam encourages Muslims to invest
their money and to become partners in order to share profits and risks in
the business instead of becoming creditors.