Devised in the 1960s by Edward Altman, a Z score indicates the probability of a company entering bankruptcy within the next two years. The higher the Z score, the lower the probability of bankruptcy. A score above three indicates that bankruptcy is unlikely; a score below 1.8 indicates that bankruptcy is possible.
It works by analysing the financial strength of a company using five balance-sheet and profit-and-loss-account measures – profit to total assets, retained earnings to total assets, working capital to total assets, sales to total assets and market capitalisation to total assets. These are then weighted to reflect their relative importance before being combined into a single figure, the Z score.