The Z score was developed in the 1960s by Edward Altman, a New York University professor, to predict the likelihood of business failure or bankruptcy. But it can also be used by healthy companies to measure financial performance and to identify potential problems early.

Altman developed the Z score by analyzing dozens of manufacturing companies, about half of which had filed for bankruptcy. The original Z score consisted of five weighted financial ratios that, when combined, could be used to distinguish the bankrupt companies in the study. The original ratios were working capital/total assets, retained earnings/total assets, EBIT (earnings before interest and taxes)/total assets, net worth/total liabilities, and sales/total assets.

Later, Altman developed a four-factor version of the Z score that eliminated sales/total assets from the equation. This version is often recommended, especially for closely held companies, because consideration of sales can sometimes artificially inflate a company’s Z score. A company with high sales but low profit margins, for example, might have a high Z score despite poor profitability.

The calculation of the Z score is outlined in the table on this page. A score less than 1.10 indicates a high likelihood of business failure. A score of more than 2.60 reflects a healthy company. Scores between 1.10 and 2.60 indicate an indeterminate rating.

Note: The numbers used in this article, which are based on Altman’s original model, are offered for illustrative purposes. Variations of the Z score have been developed that are tailored to particular types of businesses or particular industries. The R score, for example, was designed to evaluate the financial health of closely held construction companies.