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IJARAH FINANCING

DEFINITION : Ijarah is a contract whereby the owner of an asset, other thanconsumable, transfers its usufruct to another person for an agreed period at anagreed consideration.

In Islamic Finance Ijarah is a lease contract under which financial institution leasesequipment or building to its clients against agreed rentals or installments equal tothe value of the assets.

The financier is Rab-al-Maal also known as Lessor who finance equipment orbuilding to the Sarif (user or tenant) also called Lessee.

Explanation : Ijarah is a financing facility in which Rab-ul-Maal finance the asset of any nature to the Sarif on his request. In Ijarah the ownership of the assets remains

with lessor (institution) and only its right of usage is transferred to the lessee. Untilthe assets to be leased are delivered to the lessee, no lease rental becomes dueand payable. (i.e. Ijarah cannot be recorded until the subjected asset is delivered tothe lessee.) The title of the assets remains with the Lessor during the entire leaseterm. ThelLessor bears all the risk and reward associated with the ownership to theasset. All cost associated with the asset to bring it into usable form and conditionshould be borne by the lessor. In Ijarah contract the user pays the rentals for itsusage to a certain period then return the asset upon the maturity back to thefinancier. Ijarah can also be formed on the basis that the lessee will pay the price of the asset in installments over a certain period of time and the asset will be given tothe lessee for use and in return, he will pay rentals to the lessor for the usage. Therental and installment payments by the lessee lead to ownership of the asset to thelessee. Early payment of the installments by the lessee will reduce the rentals hepays and thus less is the expense on him. Financing amount is determined on thebasis of users affordability part of his gross income that he can pay for rentals andinstallments. The equity part of the user is called Arboon which is the part of thetotal amount of the financing amount. Installments are the saving part of the userand rentals are the expense that user bears for the use of the asset.

In Ijarah Working, Sarif or lessee; Mr Hammads gross monthly income is Rs75,000/-who wants to buy a car and for that he approaches to a car financing institution(Rab-ul-Maal or lessor). Mr Hammad explains to the institution that he can afford30% of his income for acquiring the car.

Mr Hammad needs a car whose market price is Rs600,000/- with insurance cost of 3% per year that is equals to Rs 18000 per year and tax cost of 1% that is equals to

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Rs 6000. Thus total cost of vehicle reaches to Rs 660,000/-(600,000+54,000+6,000).

Mr Hammad and car financing Institution reach to an agreement that Hammad willcontribute 20% of the market price of the asset i.e. Rs. 120,000/- that is termed as

Arboon which is exclusive of all costs and the institution will invest 80% and all thecosts i.e. insurance cost and tax cost which is the total Ijarah financing amountwhich is Rs. 540,000/-. The agreement is made for 3 years period of 36 equalmonthly installments.

On the basis of total 36 installments, monthly installment for ownership is Rs 15000per month. As stated above, the monthly affordability is 30% of the gross income of Rs 75000 which is equals to 22500. This monthly affordable amount is the monthlyrepayment amount of each installment. In this way, monthly rental profit will be7500 (22500-15000).

Thus after 3 years, total payment paid by the lessee to the lessor is Rs.810,000/-(540000+270000) which is 50% excess to financing facility or we can say that theinstitution earned the 50% profit on its financing amount. On the basis of thatfinanciers monthly profit is 1.4% and the yearly profit is 16.7%.

As per this Ijarah contract, 20% of Mr Hammads gross monthly income is his savingand 10% is expense out of total 30% of his saving income.

In example 1, if the car financing institution doesnt want to invest its own capital orit doesnt have the required capital to invest, it can get the required capital forijarah financing by entering into sukuk subcription. Thus the institution enters intothe Sukuk Subcription by taking a sukuk price as Rs.100 and selling these sukuks toGhulam Mohammad =1000, Ayesha=100, Seema=200, Saboor=300, AbdulMalik=400, Abdul Wakeel=500, Bank Islami=600, Bank Muslim=700, BankPakistan=400 and Scan Industries=1200. The total capital is invested for 3 years.

The cost for managing the Ijarah contract is estimated to 30% of Gross Profit andnet realized profit is divided among total sukuk issued given the net profit on eachsukuk.

As per the above Ijarah contract, the sales proceed is Rs 810,000 which is the totalpayment received by the institution against the ijarah financing amount and grossprofit is Rs 270,000 which is the total rental profit received during the Ijarah

contract period. After deducting the cost of 81000 which is the 30% of the grossprofit, net profit is realized that is amounting to Rs 189,000/- which is thendistributed among the sukuk holders according to the capital invested by eachsukuk holder as mentioned in Sukuk Subcription Working.

Profit earned on each sukuk is Rs.35/- and the ROI is 35%.

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