The Spiritual Mission of Microfinance by Mark Russell, Ph.D.

THE SPIRITUAL MISSION OF MICROFINANCE Mark Russell, Ph.D., Director of Spiritual Integration, HOPE International

ABSTRACT The paper explores the model of microfinance and how it can create community and be a servant to those in need. It argues that it needs to be intentionally integrated with the values of servant leadership so that microfinance clients become servants to their communities rather than simply wealthier people.

Jesus is undoubtedly one of the most well known leaders in human history. At the same time, he was a person who clearly served others and taught his followers to be servants of all. One of the most famous stories that Jesus taught has become known as the parable of the Good Samaritan. Jesus taught this story in reference to a question about what was the most important commandment. Jesus said two commandments, to love God and to love one’s neighbor, fulfilled the law and the prophets.

Microfinance should be seen as a tool to help people in need, not simply as a means to inject capital. Many underdeveloped countries are also countries with ethnic rivalries and social unrest and microfinance can be a space for the reconciliation of these groups.

One of the key factors in the success of microfinance is the utilization of solidarity groups. While integrating intentional reconciliation work these groups can become catalysts for reconciliation throughout the broader community and society.

Without bringing in the values of servant leadership, increased capital can spread the benefits of microfinance unevenly in a community and lead to increase tension. The uniqueness of Jesus was not that he served people, but that he led the same people to serve others.

KEYWORDS: microfinance, Christians INTRODUCTION Poverty is a daily reality for billions of people on the planet. The numbers are so staggering that we can simply become numb. Approximately 3 billion people live on less than $2 a day. The World Bank estimates that 1.4 billion people are living in extreme poverty.1 The result of this is real.

Consider the following facts:

•

Over 140 million children in developing countries are underweight and over 2 billion are undernourished.

•

Every year more than 10 million children die of hunger and preventable diseases that's over 30,000 per day and one every 3 seconds.

1

Extreme or absolute poverty is typically defined as living on less than $1 per day.

Microfinance and Faith | 3

• • • • •

800 million people go to bed hungry every day.

Every year nearly 11 million children die before their fifth birthday.

600 million children live in extreme poverty.

The three richest people in the world control more wealth than all 600 million people living in the world's poorest countries.

Income per person in the poorest countries in Africa has fallen by a quarter in the last 20 years.2

And the situation is only going to get worse. Recent increases in the price of food have had a direct and adverse effect on the poor and are expected to push many more people, millions of people, into absolute poverty. What are we, as the people of God, supposed to do about this?

One unfortunate response that many people have could be defined as fatalistic. The problem is so immense and overwhelming that some Christians simply throw up their hands and say it’s up to God. They believe that not much can be done and they refrain from trying to make a difference. Another subpar response is despair and depression.

Some Christians are so focused on the horrors of poverty and the immense suffering it produces in the lives of others that they become increasingly negative, hostile and judgmental. They are depressed and think it is wrong to be otherwise. Often they cast spiritual stones at others who are not so engaged in eliminating poverty.

However, there is a third way and, I believe it is God’s way, when it comes to responding to global poverty. This third way has two major components: 1) We recognize how we treat the poor is a reflection of how we treat Jesus.

2) We focus on approaches that work.

SOME NEW PERSPECTIVES Many people become confused when they read these words of Jesus, “The poor you will always have with you, and you can help them any time you want. But you will not always have me” (Mark 14:7). On the surface this statement appears to absolve us of responsibility of caring for the poor. However, two things must be pointed out. First, Jesus said this after Mary had poured valuable perfume on Him. Within this context, Jesus’ statement is not absolving anyone of any responsibility, but showing that the orientation of a heart toward Him is what is most important.

Second, what is little known today to most readers of the Scriptures, is that many statements in the New Testament had the purpose of directing people toward Old Testament (OT) Scriptures. This comment from Jesus starts off with a near quote of the following OT verse, “There will always be poor people in the land. Therefore I command 2

United Nations Millennium Development Goals & Oxfam International

4 | Microfinance and Faith

you to be openhanded toward your brothers and toward the poor and needy in your land” (Deuteronomy 15:11). So, Jesus is not saying that we should not care for the poor, but rather that we should first have a heart committed to Him. Then we should be “openhanded” toward “the poor and needy” in our world.

This truth is brought home when Jesus said quite clearly, “I tell you the truth, whatever you did for one of the least of these brothers of mine, you did for me” (Matthew 25:40).

Perhaps sensing that many people might just choose to opt out of doing something good, Jesus made clear that not doing good is the equivalent of doing bad when he flipped the phrase saying, “I tell you the truth, whatever you did not do for one of the least of these, you did not do for me” (Matthew 25:45). So, how we treat the poor is a reflection of how we treat Jesus.

God created a beautiful world, prepared for those created in His image to be enjoyed with abundance and blessing (Genesis 1:28). But this world has been corrupted and broken and we are in a world of scarcity and cursing. The ones who suffer the most are the poor.

God created us to build community together and to work his creation (Genesis 1:28).

Poverty tends to disrupt genuine community and prevents people from engaging in the dignified work that God intended. Even in prosperous, developed countries, finances are a primary cause of stress and problem within marriages. The same is true the world over.

Where there are financial pressures, relationships tend to dissolve. Where that pressure is immense, rioting and war can even result.

Part of the mission of the church is not only to treat “the least of these” with respect and dignity, but also to find real and practical ways we can restore them to the life that God intends for them. We need to focus on interventions that work.

THE LINK TO MICROFINANCE A recent United Nations Millennium Development goal report said that the number one intervention that has worked to eradicate poverty in the last eight years is microfinance.

Microfinance is an umbrella term that refers to the provision of small loans and other financial services such as savings and micro-insurance to people who are cut out of traditional banking structures. Microfinance has helped many of the world’s poor to increase their incomes. In 2006, microfinance institutions provided loans to approximately 113 million clients worldwide.

Although there are 113 million microfinance clients in the world, there are approximately another 550 million people who would benefit from microfinance but do not have access to it. We are reaching less than 20% of the people who most desperately need it. Of the people who are being reached only about 1% are being served through Christian microfinance institutions (CMFI). That means that CMFI’s are serving less than one fifth of one percent of the need.

At church and academic conferences I frequently give this information about the lack of access to basic microfinance and ask if it’s a problem that CMFI’s and the Church as a whole are not making a bigger impact. Quite often the general response is that the biggest problem is that people do not have access to these basic financial services and it does not really matter who the provider is. These responses demonstrate to me that many people of Microfinance and Faith | 5

faith still do not understand poverty and the spiritual mission of microfinance.

As a citizen and resident of the wealthiest nation in the history of the world, I have observed that access to financial capital is not the solution to the world’s problems.

Increased wealth can lead to a decreased spirituality. Greed can flourish where the economy prospers. However, in saying that, the extremity and scale of poverty in the world today needs a financial response. These people do need financial capital. But that is not all that they need.

THE INTEGRATION Recently, I visited with a microfinance client in the Democratic Republic of Congo who is a microfinance success story. He had built his salon business up and was generating significant profits. He had been able to construct a new building for his business.

However, he was a functional alcoholic. 3 The vast majority of his profits had been consumed with his business and his alcohol. When his loan officer at a CMFI confronted him on his alcoholism and offered him new life in Christ, the man was changed. He became a follower of Christ and gave us his expensive alcohol habit. When I asked him what tangible result this had on the lives of others around him, he confessed that he was now able to buy milk for his six children. Though this man was a microfinance success story, the benefits of that improved lifestyle did not even trickle down to his own children until God changed his heart.

The spiritual mission of microfinance is not to simply help the poor be less poor, but it is to radically transform their lives and give them the practical and spiritual tools to live life as God intends. We want to help the poor, but it is not like solving a math problem.

Microfinance is a solution that works, but it only helps in so far as we understand what the real problem is. We are working to change the world in which we live, not just make people wealthier. We need to eradicate spiritual and physical poverty. That is the spiritual mission of microfinance.

3

A functional alcoholic is someone who consumes alcohol as an addiction and extensively but is still able to function as a well performing person.

6 | Microfinance and Faith

FINANCING SMALL ENTERPRISES THROUGH MUDHARABAH Yahsoub Al-Eryani, Ph.D., Vice Dean, Arab Academy for Banking and Financial Sciences Kais Aliriani, MBA, Director, Investpro Inc. and Manal Al-Asbahi, MBA Candidate, AABFS

ABSTRACT Small enterprises in Yemen, like many other countries, lack the financial means to develop. They have limited access to the traditional lending market. In Yemen, small entrepreneurs need more innovative approaches to finance, and Islamic financing tools are gaining popularity as an alternative to traditional loans. This research investigates the characteristics of mudharabah (an Islamic financing tool) and how it could be used to finance small enterprises, comparing it to other financing tools. It also surveys the use of mudharabah among financiers and clients.

Financial ratios were used to compare conventional lending, Murabaha (another Islamic financing tool), and mudharabah. The conclusion is that there are differences between the three financing tools with regard to liquidity of small enterprises, with mudharabah being the best for small enterprises. On the other hand, there are no significant differences between the three financing tools with regard to profitability and solvency of small enterprises.

Mudharabah, as a new financing tool, could be a good tool for financing small enterprises. It could contribute with other Islamic financing tools in filling the gap in lending to small enterprises. There is, however, a lack of knowledge about mudharabah among financiers, and clients. Mudharabah, and other Islamic financing tools, need be further developed, and experimented in financing small enterprises, so further empirical research could take place.

KEYWORDS: finance, murabahah,Yemen, lending

small

enterprises,

Islamic

finance,

mudharabah,

INTRODUCTION Small enterprises play an important role in the economies of countries regardless of their development stage. They contribute to economic development by creating jobs and incomes to large numbers of people. The contribution of SMEs has been demonstrated in both developing and developed countries. Mahatma Ghandi in one of his famous quotes defined development as “putting in the front those that society usually puts in the back�.

A small enterprise is an enterprise that uses a limited number of employees. It is managed by owners and it usually serves the local market. It is a form of self employment. SMEs, like other projects, need financing. Finance is the foundation of any small project. Decision makers need to make essential decisions related to the finances Microfinance and Faith | 7

of the enterprise, including the source of funds, and their use, to achieve the highest return with the lowest risk.

The number of organizations that provide finance to SMEs in Yemen is still limited.

Banks are reluctant to finance SMEs due to the lack of traditional collaterals. In addition, SMEs have limited capacity in planning and proposal writing, which further limits their access to finance. In many cases SMEs depend on their own savings to run business.

This limits their ability to grow. With better financing facilities SMEs could significantly increase their contribution to the economy. This is especially true in a country like Yemen that suffers from high unemployment.

In this study the researchers introduce traditional lending, murabahah, and mudharabah as three methods to finance SMEs. A comparison between the three lending methodologies is presented. Liquidity, profitability, and other financial ratios are used in the comparison. The efficiency of each methodology in financing SMEs is discussed.

For the purpose of this research the following definition are used: -

Lending: or “traditional lending� is a contract between a borrower and a lender.

The borrower receives a cash advance (a loan) from the lender. The loan plus a premium (interest) is paid back by the borrower on specified time schedule.

-

Murabahah: an Islamic financing tool. It involved the buying and selling contract between two parties. The financier (bank) buys the goods required by the client and resells them to the client at a mark up. The client is then required to pay the price at a later time. (Gait,2007). Murabahah is widely used by Islamic banks.

-

Mudharabah: an Islamic financing tool. It is a contract between two parties: an investor (individual or institution) who provides the entrepreneur with financial resources to finance a particular project (Gait, 2007). The risks of the project are shared between the two parties and profits as well as losses are shared at the end of the agreed period.

-

Entrepreneur/ client: owner of small business.

-

Financier: the entity that provides finance to SMEs.

IMPORTANCE OF THE RESEARCH SMEs in Yemen have limited access to financing sources (Elk, 2000). In addition to the fact that they are not able to access funds from banks due to the high requirements of guarantees, many SMEs owners prefer Islamic banking products, which are not readily available. The importance of this research is to learn about the different financing methods in the search for suitable methods to finance SMEs. 8 | Microfinance and Faith

Financial analysis and financial ratios are used to compare the different financing methods, both traditional and Islamic. This comparison is used to find if there is any preferred way that best suits the needs of SMEs. The research also looks in more details into mudharabah financing. A mechanism for mudharabah financing is proposed, in addition to several guidelines and recommendations that could help organization that are interested in using mudharabah as a mean to finance SMEs. The research could help increase the use of mudharabah in financing SMEs, and hence increase the financing available to SMEs.

RESEARCH PROBLEM The problem the research is trying to solve is to answer the following questions: 1. What are the differences between the methods of financing SMEs, and how could these differences be identified and measured?

2. What is the possibility of using mudharabah as a financing tool for SMEs, and how is it compared to traditional lending and murabahah?

RESEARCH OBJECTIVES The objective of this research is to investigate the use of mudharabah as a financing method for small enterprises, and compare its use to other financing methods. To achieve this objective the research will include: 1. Using mudharabah as a financing methodology.

2. Proposing a mechanism to use mudharabah in institutions that finance SMEs. 3. Comparing the effect of the different lending methodologies on SMEs. 4. Drawing some suggestions and recommendations that help SMEs in choosing the appropriate financing method.

RESEARCH QUESTIONS 1. Are there any differences between the various financing methods with regard to the liquidity ratios of SMEs? - To answer this question the following questions need to be answered: a. Are there any differences between lending and mudharabah with regard to liquidity ratio (L3)? b. Are there any differences between murabahah and mudharabah with regard to liquidity ratio (L3)?

2. Are there any differences between the different financing methods with regard to profitability ratios of SMEs? To answer this question the following questions need to be answered: a. Are there any differences between lending and mudharabah with regard to profitability ratios (P1, P2, P4, P5, P6)?

Microfinance and Faith | 9

b. Are there any differences between murabahah and mudharabah with regard to profitability ratios (P1, P2, P4, P5, P6)?

3. Are there differences between the various financing methods with regard to solvency ratios of SMEs? To answer this question the following questions need to be answered: a. Are there any differences between lending and mudharabah with regard to solvency ratios (S1, S2, S3, S4, S5, S6)? b. Are there any differences between murabahah and mudharabah with regard to profitability ratios (S1, S2, S3, S4, S5, S6)?

PREVIOUS RESEARCH (1)

Application of Islamic Banking on Microfinance (Dhumale, 1998).

One of the main principals of Islamic Banking is risk sharing, which reduces the need for hard collaterals for some types of loans. This is very suitable for some SMEs, and it encourages the establishment of new SMEs. The spread of these types of financing could help reach the poor, and encourage development. Islamic law allows for innovation in financial dealings. Several Islamic contractual arrangements could be used to come up with a new arrangement. Observing practices of successful microfinance institutions with some modifications to Islamic financial dealings, Islamic banking could provide alternatives in microfinance. Those enterprises that are rejected by traditional lending institutions because of the lack of hard collaterals could be acceptable by Islamic banks, based on profit sharing principals.

In some circumstances, the mudharabah (profit sharing) model, and the murabahah (buyresell) model, could be suitable for microfinance. Although murabahah results in higher initial administration costs, these costs could be offset by reducing the costs of administration and follow up of loans, due to the simplicity of the model.

Although the mudharabah model requires continuous assessment of project profits, it could still be used practically to achieve the objective of financing SMEs. The study discusses two financing methods using a simple hypothetical example for lending. Our research, however, is carried on real projects financed by murabahah and traditional loans. Mudharabah is applied to see the differences in financing methods and their effects on SMEs. (2)

Small business finance in Italy (www.eib.org, 2009):

This paper talks about financing SMEs in Italy through bank loans. 25% of industrial companies have no bank loans, and this percentage is higher among small companies.

Companies with loans have capital structure similar to larger companies.

10 | Microfinance and Faith

The paper demonstrates that the lack of bank loans in the balance sheets of many companies is either due to the voluntary choice of companies not to borrow, or due to the rejection of banks. The percentage of companies without a loan is higher than those with a loan. Companies that already have loans are not usually rejected from having another.

Ownership is also an important factor in the access to the credit market. In the study, one model of financing is used, not other options are studied.

(3) Small and Medium Industries in the Republic of Yemen- Obstacles to growth, and Methods for Development (Qaid, 2007) This study is an attempt to unleash the obstacles that small and medium enterprises in Yemen are facing, and to provide some suggestions to help develop them.

The study covered three areas: • A General overview of small and medium enterprises, definition, characteristics, relation to Yemeni economy, and indicators of their contribution to the economy.

• Obstacles of growth the development of small and medium enterprises and analysis of the most important obstacles.

• Suggested strategies to develop small and medium enterprises The study was concluded that there is a lack of a universal definition of SMEs in Yemen.

It also confirms the importance of SMEs in the Yemeni economy, and highlights the most important obstacles to growth, one of which is the lack of financing opportunities.

(4) The Role of Islamic Banks in Financing SMES, an applied research in Jeddah City (Nasseef, 2006) SMEs find difficulties in securing finance for their activities. Islamic banks have opportunity in tapping this market, especially that many small entrepreneurs prefer Islamic financing. The objective of the research is to learn about the obstacles that SMEs face when they deal with Islamic banks (in Jeddah City, Saudi Arabia). In addition, the research investigates the Islamic financing methods that suit SMEs. A field study was done on SMEs and a few results were reached.

• The quality of banking services and the marketing activities of the bank are very important in the client’s decision to select an Islamic bank.

• Small entrepreneurs need to pay more attention to training, and improve their investment awareness.

• Islamic banks need to invest more in marketing as well as in the development of new financing methods.

POPULATION AND SAMPLE OF THE STUDY The population of the study is two institutions specialized in financing SMEs in Sana’a City (Yemen); namely the Small Enterprise Development Fund, which uses traditional lending, and Azal Lending Program, which uses murabahah. The sample for the study was chosen randomly from each institution. 20 projects were chosen, with the condition Microfinance and Faith | 11

that they were financed for working capital during the period 2004-2007, and have fully repaid their loans. Loan size ranges from YR 20,000 to YR 600,0000.

Two research methods were used in this study. Descriptive analysis method was used in data collection related to murabahah and Traditional Lending and the analysis of the data.

Experimental research method was used in applying mudharabah on the data from the institution that uses murabahah, and the data from the institution that uses traditional lending. The objective is to learn about the advantages and disadvantages of the different financing methodologies, and the applicability of mudharabah as a tool used to finance SMEs, and its potential benefits to SMEs.

DATA COLLECTION TOOLS 1. Interviews: interviews were used to get the feedback of individuals on the different financing methods of SMEs and learn about the procedures used to finance SMEs. They were also used to collect documents and data related to the research sample.

2. Office Resources: To enrich the research, a literature study about the subject was done.

FINANCIAL ANALYSIS In this research financial ratios are used in analyzing the feasibility of SMEs, and how profitable they are. The ratios used in this research are: Liquidity Ratios: liquidity ratios are used as a tool to evaluate the credit worthiness of an enterprise. It measures the ability of the enterprise to fulfill its short term obligations (Matar, 2006).

L3: Current Ratio = current assets/ current liabilities: shows how assets are covering current liabilities, so it measures the financial balance. It measures the project ability to fulfill short term liabilities (Shabib, 2007).

Profitability Ratios: shows how profitable the project is (Al-Najjar, 1999).

P1: Net Profit to Total Assets = net after tax profits/ total assets : this ratio measures the effectiveness of the enterprise in managing available funds (whether they are assets or borrowed) to generate income (Shaker, 2005).

P2: Return On Equity (ROE) = net profit after tax and before interest/ Equity: this ratio shows the profitability of equity, the higher the ratio the better it is for owners, since net profits will be distributed among them (Al-Maidani, 2004).

12 | Microfinance and Faith

P3: Gross Profit Margin= ((sales-cost of sales)/sales)= (Gross profit/sales): this ratio measures the ability of each Riyal (unit of currency) of sales to generate gross profits (AlRawi, 2000).

P4: Profit Margin Ratio= net after tax profit/sales: this ratio measures the ability of one Riyal (unit of currency) of sales to generate profits. The higher the ratio, the better (Shaker, 2005).

P5: Return on Assets= net before tax profits/ total assets: this ratio shows how effective the enterprise has been in using its available financial resources, regardless of their sources (Al-Khalailah, 2004) P6: Return on Investment= net before interest and after tax profits / Invested capital: this ratio measures the profitability of invested funds, the higher is the ratio the better (Shaker, 2005).

Solvency Ratios: measures the contribution of owners and creditors in funding the project (Al-Zoghbi, 2000) S1: Equity to Total Assets = Equity/Total Assets: the portion of assets that is financed by equity, this ratio measures the project’s ability to finance its assets (Matar, 2006).

S2: Total Assets to Total Liabilities = Total Assets/Total Liabilities: this ratio measures how the total assets cover the total liabilities, and the ability of the project to fulfill its obligations.

S3: Equity to total liabilities= Equity/Total liabilities: measures the project’s ability to finance its liabilities by its own funds, the higher the ratio the more independent the project is (Shaker, 2005).

S4: Debt-Asset Ratio= Debts/ Total Assets : the ratio measures the contribution of lenders in financing the project, the higher the ratio the higher is the credit risk, and the higher is the cost of financing (Al-Rawi, 2000) S5: Current Liabilities to Equity= Current Liabilities/ Equity: this ratio measures the short term liabilities to equity. The lower the ratio the more confident creditors will be (Al-Zoghbi, 2000).

S6: Debts to Capital= Debts/ Capital: this ratio shows the percentage of debts in comparison to the capital.

In the experiment mudharabah was applied on the SMEs that were actually financed by murabahah. The murabahah rate was ignored, and the actual cost of finance was used.

The contribution of the financier in the project was proposed to be 35%, and the entrepreneur was 65%. The profits at the end of the financial year were calculated at 21 % for the financier and 79% for the entrepreneur.

Microfinance and Faith | 13

ANSWERS TO RESEARCH QUESTIONS

1. Answer to Question 1: Are there any differences between the various financing methods with regard to the liquidity ratios of SMEs? To answer this question the following questions are answered: a. Are there any differences between lending and mudharabah with regard to liquidity ratio (L3)?

TABLE (1): DIFFERENCES BETWEEN LENDING AND MUDHARABAH IN TERMS OF LIQUIDITY RATIOS Liquidity Ratio Lending Mudharabah Details 1.957 2.174 Mudharabah financing is better than lending L3

Table (1) shows that there is a difference between Lending and mudharabah in terms of liquidity ratio (L3) in favor of mudharabah.

b. Are there any differences between murabahah and mudharabah with regard to liquidity ratio (L3)?

TABLE (2) DIFFERENCES BETWEEN MURABAHAH AND MUDHARABAH IN TERMS OF LIQUIDITY RATIOS Liquidity Ratio Murabahah Mudharabah Details L3

5.936

6.907

Mudharabah Financing murabahah financing.

is

better

than

Table (2) shows that there are differences between murabahah and mudharabah in terms of liquidity ratios in favor of mudharabah.

2. Answer to Question 2: Are there differences between the various financing methods with regard to profitability ratios of SMEs? To answer this question the following questions are answered: a. Are there any differences between lending and mudharabah with regard to profitability ratios (P1, P2, P4, P5, P6)?

TABLE (3): DIFFERENCES IN PROFITABILITY RATIOS BETWEEN LENDING AND MUDHARABAH Profitability Lending Mudharabah Details Ratio Lending finance is better than P1 2.529 2.312 mudharabah Lending finance is better than P2 0.709 0.626 mudharabah Lending finance is better than P4 0.189 0.173 mudharabah

14 | Microfinance and Faith

P5

2.572

2.314

P6

3.415

3.056

Lending finance is better than mudharabah Lending finance is better than mudharabah

Table (3) shows that differences in profitability ratios between Lending and mudharabah are negligible. Profitability of SMEs financed by lending is slightly higher.

Using profitability ratios and liquidity ratios to analyze the differences between Lending and mudharabah, it was demonstrated that there is a reciprocal relation between the profitability of SMEs and their ability to fulfill obligations using the available liquidity. b. Are there any differences between murabahah and mudharabah with regard to profitability ratios (P1, P2, P4, P5, P6)?

TABLE (4) DIFFERENCE IN PROFITABILITY RATIOS BETWEEN MURABAHAH AND MUDHARABAH Profitability Ratio Murabahah Mudharabah Details There is slight difference in favor P1 0.332 0.326 of murabahah There is slight difference in favor P2 0.254 0.228 of murabahah There is slight difference in favor P4 0.086 0.085 of murabahah There is slight difference in favor P5 0.353 0.326 of murabahah Murabahah Financing is better P6 0.563 0.516 than mudharabah

Table (4) shows that there are no significant differences in terms of profitability between murabahah and mudharabah. Projects financed by murabahah were slightly more profitable than those financed by mudharabah. This does not mean that murabahah is better than mudharabah.

The analysis of the profitability ratios and liquidity ratios (L3) for murabahah and mudharabah reveals a reciprocal relation between the profitability of SMEs and their ability to fulfill their obligations using the available liquidity.

Although the analysis shows that Lending and murabahah are better than mudharabah, the differences are very small, and there were some examples of SMEs that actually had higher profits with mudharabah financing. The analysis shows that mudharabah is better for the financier than murabahah and Lending.

The comparison between murabahah and mudharabah shows that the ratios are comparable. Since both are Islamic financing methods, mudharabah could be used to finance working capital, while murabahah could be used to finance assets (machines), Microfinance and Faith | 15

that is because it is usually difficult to find the real income from “one machine� in a whole project, so it is difficult to use mudharabah. On the other hand, murabahah does not require assessment of profits from the project, so it is easier.

The financier could ask for bigger share when financing with mudharabah since it has many advantages for the entrepreneur. First the financier shares the financial risk in case of losses, in such case the entrepreneur is not obliged to repay the whole financing amount back (as in Lending and murabahah) . In addition, and since profits are shared at the end of the financial year, the entrepreneur is not under pressure to pay installments.

3. Answer to Question 3: Are there any differences between the various financing methods with regard to solvency and profitability ratios of SMEs? To answer this question the following questions are answered: a. Are there any differences between Lending and mudharabah with regard to solvency ratios (S1, S2, S3, S4, S5, S6)?

TABLE (5): COMPARISON OF SOLVENCY RATIOS BETWEEN LENDING AND MUDHARABAH Solvency Ratios Lending Mudharabh Details Mudharabah Financing is better than S1 3.179 3.221 Lending Mudharabah Financing is better than S2 2.663 2.954 Lending Mudharabah Financing is better than S3 8.253 9.329 Lending Mudharabah Financing is better than S4 0.387 0.346 Lending Mudharabah Financing is better than S5 17.038 14.970 Lending Mudharabah Financing is better than S6 0.616 0.549 Lending

Table (5) shows small differences in ratios between the two methods, with some preference for mudharabah. b. Are there any differences between murabahah and mudharabah with regard to solvency ratios (S1, S2, S3, S4, S5, S6)?

TABLE (6): COMPARISON OF SOLVANCY RATIOS OF MURABAHAH AND MUDHARABH Solvency Murabahah Mudharabah Details Ratios Mudharabah Financing is better than S1 1.199 1.220 murabahah Mudharabah Financing is better than S2 11.482 13.411 murabahah S3 13.136 5.244 Murabahah is better than mudharabah S4 0.132 0.112 Murabahah is better than mudharabah

16 | Microfinance and Faith

S5

11.344

15.536

S6

0.153

0.139

Mudharabah Financing is better than murabahah Murabahah is better than mudharabah

Table (6) shows little differences between the two methods, with some preference for mudharabah.

The results of the analysis show that there are some differences between the financing methods under consideration, sometimes in favor of mudharabah, others in favor of Lending or murabahah. Taking a closer look at the methods we could see the advantages of each.

Mudharabah is a profit and risk sharing arrangement. It is sometimes preferred by entrepreneurs because it gives them some psychological support. Unlike other methods, mudharabah could allow entrepreneur to adjust his/her plans to changes in the environment, and make better profits. Entrepreneur does not have to worry about the fixed schedule of repayments. In addition mudharabah is recognized as a lawful method of financing in the Islamic Sharia (Islamic law). It could be a good alternative for entrepreneurs who are reluctant to get financing either because they think it is Riba (or Usury that is prohibited by Islamic Law), or they fear making commitment to a fixed repayment schedule. In a way mudharabah seems to be fair, since benefits as well as risks are shared between financier and client.

On the other hand, mudharabah requires special strategy by financier. Unlike other methods, the financier must understand the business and be convinced that it could generate the profits required. Financier must also follow up to ensure that the project is performing according to plans. The entrepreneur needs also to understand that partnership requirement. S/he needs to be transparent and ready to share the information with the financier. S/he needs to put every effort to increase the income and reduce the costs.

Traditional lending is a common financing method. It requires little effort from the borrower and the lender to organize. The gains of the lender (interest) are fixed up front, and the cost to the borrower is also fixed. The lender assumes no risk, so the borrower has a disadvantage. Regardless of the outcome of the business, the borrower must repay the loan. The borrower is usually required to present hard collateral to secure repayment in case of default, so the borrower is putting at risk some of his/her assets in order to get the facility. In many cases borrowers find difficulties in securing the collaterals, so they lose the ability to get finance. murabahah in many ways is similar to traditional lending. The difference is the requirement from lender to actually take acquisition of the asset (subject of the financing) and resell it to the borrower. It requires additional management effort from the lender. It could also complicate the acquisition of the asset by the

Microfinance and Faith | 17

borrower. What has been mentioned about the advantages and disadvantages of traditional lending holds true for murabahah.

PROPOSED MECHANISM FOR THE USE OF MUDHARABAH IN SMEs FINANCING Mudharabah is a tool that could be used to facilitate the provision of finance to SMEs. As a risk-sharing mechanism it will encourage entrepreneurs to get finance. With the deeper involvement of the financier in the business, the SME owner could benefit from the experience of the financier. The need for collaterals from the part of the financier is reduced because the financier will have better understanding of the business, as a partner.

The financier shares the risk, but also the benefits, which could be much higher and improve the return. Inflation risk is reduced with sharing. The entrepreneur has more confidence, but also holds more responsibility. S/he is held responsible in case of mismanagement or ignorance.

In the following the researchers present some of the aspects that need to be observed, and the tools that could be used to improve the use of mudharabah in SMEs financing.

Suggested conditions related to mudharabah: To encourage the use of mudharabah in SME financing, the following should be considered by financiers and entrepreneurs, and organizations that want to make more mudharabah financing available to SMEs: • • • •

• • •

Financiers need to establish separate units, or departments specialized in mudharabah.

Financiers should have a clear definition of SMEs. There should be a mechanism to exchange experience related to the finance of SMEs by mudharabah. Studies could be done to learn from those experiences.

There should be a mechanism to help SMEs improve their competitiveness by providing training the coaching. Mudharabah and its advantages could be introduced to entrepreneurs.

Financiers need to build their knowledge about SMEs and their experience in dealing with this sector.

To encourage mudharabah financing, a credit guarantee mechanism need to be introduced to help financiers reduce the risk of financing.

The use of controlled-mudharabah is appropriate, especially at the initial stage.

Controlled mudharabah is limited by time, whereas un-controlled mudharabah is not limited by time, nor space, or type of business. Due to the difficulty in measuring the profits that come from machines and equipment, traditional lending and murabahah could be used to finance them.

18 | Microfinance and Faith

THE ACCOUNTING CYCLE OF MUDHARABAH FINANCING FIGURE 1: THE ACCOUNTING CYCLE OF MUDHARABAH FINANCING Investment Department

Entrepreneur

Entrepreneur

Head of Investment Department ( responsible of SMEs financing)

Investment Department

Archive

Entrepreneur

Entrepreneur

Feasibility Study form

Feasibility Study form

Feasibility Study form

Entrepreneur

Entrepreneur

save save

Audit Audit

Execution order

Microfinance and Faith | 19

FIGURE (2): ACCOUNTING CYCLE FOR THE PAYMENT OF MUDHARABAH FUNDS Investment Department

Cashier

Investment Department

Achieve

Entrepreneur Payment Receipt Payment order Feasibility Study form

Payment Receipt Entrepreneur Issue of payment receipt

Cash Receipt

Mudharabah Execution Order Mudharabah Contract Fund payment order

Mudharabah Contract Payment Receipt Save Entrepreneur

Auditing

PROCEDURES FOR THE USE OF MUDHARABAH IN SME FINANCE: 1. Entrepreneur fills an application using a form that specifies the amount required, the purpose, and the time in addition to any details that clarifies the application.

2. Application is carefully reviewed and compared to the policy of the financier. A full study of the application is done by a specialist who gives special attention to: o the character of the entrepreneur. o the experience of the entrepreneur.

3. A feasibility study is preformed for the project, including market study, income, and risks.

4. A report about the results of the appraisal of the application is forwarded to a committee that makes the decision about the application.

5. In case of acceptance of the application the entrepreneur is informed about the acceptance and the conditions of the financing.

6. The entrepreneur presents the required documents, and signs the contract.

7. The financier opens an account under the name of the entrepreneur.

8. The entrepreneur manages the process of buying and selling using his/her best judgment and observing the contract with the financier.

9. Financier follows up the entrepreneur regularly.

20 | Microfinance and Faith

10. At the end of the contract, the profits are calculated and distributed between the financier and entrepreneur.

In addition, the following could be considered: - The entrepreneur could be required to provide a guarantee against the risk of ignorance or mismanagement.

- The entrepreneurs could be asked to provide periodic reports to the financier.

- In case of loss, the financier losses the funds, or part of them, as long as there is no mismanagement by the entrepreneur.

FIGURE 3: MUDHARABAH FINANCING PROCEDURES Entrepreneur

Application

Review of Application

Feasibility Study of Project

Rejected

Review of report by committee

Informing Entrepreneur

Accepted Informing Entrepreneur about financing terms

Presenting Required Documents and Signing of Contract

Follow up

Source: Researchers

Microfinance and Faith | 21

RESULTS OF THE RESEARCH First: Results of Financial Analysis 1. Answer to question 1: Are there any differences between the various financing methods with regard to liquidity of SMEs? a. There are differences between lding and mudharabah with regard to liquidity raios L3, mudharabah results in higher liquidity ratios. b. There are differences between murabahah and mudharabah with regard to liquidity ratios L3, mudharabah result in higher liquidity ratios.

2. Answer to question 2: Are there any differences between the various financing methods with regard to profitability of SMEs? a. There are slight differences between lending and mudharabah with regard to profitability ratios (p1, p2, p4, p5, p6). Lending results in higher profitability. b. There are slight differences between murabahah and mudharabah with regard to profitability ratios (p1, p2, p4, p5, p6). Murabahah results in higher profitability.

3. Answer to question 3: Are there any significant differences between the various financing mehthods with regard to the solvency of SMEs? a. There are slight differences between lending and mudharabah with regard to solvency ratios (s1, s2, s3, s4, s5, s6). Mudharabah results in higher solvency ratios. b. There are slight differences between murabahah and mudharabah with regard to profitability ratios (s1, s2, s3, s4, s5, s6). Mudharabah results in higher profitability.

Second: Other Results: The following could be concluded from the research.

1. Mudharabah could be used as a financing tool for SMEs, and is sometimes preferred by entrepreneurs (Dhumale, 1998).

2. Mudharabah is particularly suitable for enterprises that need working capital financing.

3. Mudharabah financing could provide reasonable profits for the enterprise and the financiers.

4. Mudharabah financing enables entrepreneur to adjust to the changes in work procedures.

5. Mudharabah financing gives SMEs more chances to sustain and grow.

6. Mudharabah helps in reducing the inflation risk to the financier.

7. Mudharabah can help achieve fair distribution of benefits between financier and entrepreneur.

8. Using mudharabah can help reduce the need for collaterals, which will result in increasing financing to SMEs. 9- There is no common definition of SMEs in Yemen.

10- Lending and murabahah financing are less flexible than mudharabah since they are governed by a fixed repayment schedules and collaterals.

11- There is a lack of knowledge about mudharabah among entrepreneurs and financiers.

22 | Microfinance and Faith

RECOMMENDATIONS: Based on the results of the research, the following recommendations are proposed: 1. Introducing mudharabah as a tool to finance SMEs. 2. Performing a real study on mudharabah using the ratios presented in this research on projects that are financed by mudharabah to compare the results to those presented in this research.

3. Establishing an organization, or a window, that is specialized in mudharabah financing.

4. Establishing a common definition of SMEs in Yemen.

5. Raising the awareness of entrepreneurs about mudharabah and how it could be used to finance SMEs. 6. Encouraging more research on the alternative Islamic financial tools like ejarah, musharakah, and istesna.

REFERENCES Al-Khalailah, Mahmoud A. (2004) “The use of Accounting Data in Financial Analysis”, Amman, Jordan, 3rd Edition, p. 115 Al-Maidani, Mohammed (2004) “Financial Management in Companies”, Obaikan House, Ed. 4, p. 145.

Al-Najjar, Farid (1999) “Management of Small Enterprises”, Alexanderia, p. 97 Al-Rawi, Kahled (2000) “Analysis of Financial Statements, and Disclosure”, Al-Maserah House, Amman, Jordan, p. 64, 75 Al-Zoghbi, Haitahm (2000) “ Management and Financial Analysis”, Al-Fikr House, Amman, Jordan, p. 242 Dhumale, Rahul and Amela Sapcanin (1998). “An Application of Islamic Banking Principles to Microfinance- A technical note” Retrieved July 13, 2009 from http://www.mafhoum.com/press/54E19.pdf, p. 11 Elk, Van Koos and Paul Winminian (2000), The Baseline Survey of Small and Micro Enterprises in Yemen, Netherland Economic Institute, Sana’a p. 7.

Gait, A. and Worthington (2007). “A primer on Islamic Finance: Definitions, Sources, Principles and Methods”, University of Wollongong, Retrieved on July 5, 2009 from http://ro.uow.edu.au/cgi/viewcontent.cgi?article=1359&context=commpapers, p. 15,17 Lyman Timothy R., Mahieux, Thierry, Reille, Xavier" Microfinance in Yemen" Report of CGAP Multi-Donor Mission, June 2005. P.7

Microfinance and Faith | 23

Matar, Mohammed (2006) “Modern Trends in Financial Analysis and Credit” Al-Awael Publishing, Second Edition, Amman, Jordan, p. 34, 61 Naseef, Ghadah (2006) “Role of Islamic Banks in Financing Small Enterprises, applied research” Jeddah City, Master’s research.

Qaid, Ali (2007). “Small Enterprises in the Republic of Yemen: Obstacles to growth and Methods to Development”, Arab Forum for SMEs, Sana’a 25-26/11/2007.

Shabib (2007) “Introduction to Modern Financial Management” Al-Maserah Publishing, Amman, Jordan, p.85 Shaker and others (2005) “Financial Analysis- an Introduction to Decision Making”, Wael Publishing, Amman, p. 62, 66, 182,185

24 | Microfinance and Faith