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Distress early warning signal detector

Evaluates a company's financial and operational metrics against a six-domain distress indicator framework — EBITDA margin trend, covenant headroom, cash conversion, customer concentration, working capital, and…

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Purpose

Detect the early, leading signs of financial and operational distress in a company — before they show up as a covenant breach or a missed payroll — and convert scattered metrics into a single risk rating with ranked priority flags. Solves the problem of late-stage surprises: distress is almost always visible in the trend data months before it becomes a crisis.

When to Use

Invoke this skill when the user asks to:

  • Assess the financial health of a portfolio company or investment
  • Screen for early warning signs of distress before a quarterly board meeting
  • Decide whether a company needs intervention, a turnaround plan, or closer monitoring
  • Validate whether management's narrative matches the underlying metrics
  • Compare distress risk across multiple companies in a portfolio
  • Build an ongoing watchlist of leading indicators to track

Inputs Required

Before starting, collect:

  • Financials (3+ periods): Revenue, EBITDA, net income, and balance sheet for at least the trailing 3 quarters or 3 years
  • Debt structure & covenants: Total debt, facility terms, and the specific financial covenants with their thresholds (e.g., max leverage, min fixed-charge coverage)
  • Cash position & conversion: Current cash balance, free cash flow, and DSO/DPO/DIO if available
  • Customer concentration: Revenue share of the top 1, 5, and 10 customers
  • Working capital detail: Receivables, payables, and inventory trends
  • Management & organizational signals: Recent C-suite/board turnover, key departures, or hiring freezes
  • Industry/context: Sector, comparable margin benchmarks, and any known macro headwinds

If covenant thresholds or customer concentration are unavailable, score the domain on available proxies and flag it as a data gap that materially limits confidence.

Instructions

Step 1: Score the Six Distress Domains

For each domain, assign a status — Green (healthy), Amber (watch), or Red (distress signal) — based on the trend, not the absolute level. A declining trajectory in a healthy company is more predictive than a stable one in a stressed company.

Domain 1 — EBITDA Margin Deterioration

  • Compare EBITDA margin across the last 3 periods.
  • Amber: Margin down 100–300 bps over the trend window, or flat while revenue grows (operating deleverage)
  • Red: Margin down 300+ bps, two consecutive periods of decline, or margin turning negative
  • Distinguish structural decline (pricing/cost base) from one-time items — note which.

Domain 2 — Covenant Headroom Erosion

  • Calculate current headroom against each covenant: (threshold − actual) / threshold.
  • Amber: Headroom under 20% on any covenant, or headroom shrinking each period
  • Red: Headroom under 10%, a projected breach within 2 quarters at current trajectory, or any actual breach/waiver in the trailing 12 months
  • Model the next-quarter covenant position using the EBITDA trend, not the trailing figure.

Domain 3 — Cash Conversion Decline

  • Calculate cash conversion: free cash flow / EBITDA (or operating cash flow / EBITDA).
  • Amber: Conversion below 60%, or a 15+ point decline period-over-period
  • Red: Conversion below 40%, negative free cash flow, or EBITDA growing while cash flow shrinks (an earnings-quality red flag)
  • Earnings that don't convert to cash are the single most reliable distress predictor.

Domain 4 — Customer Concentration Risk

  • Assess revenue dependence on the top customers.
  • Amber: Top customer over 15% of revenue, or top 5 over 40%
  • Red: Top customer over 25%, top 5 over 60%, or any sign of a key account at risk (contract expiry, reduced orders, payment delays)
  • Concentration is a latent risk that becomes acute the moment one account wobbles.

Domain 5 — Working Capital Deterioration

  • Track the cash conversion cycle (DSO + DIO − DPO) and its components over the trend window.
  • Amber: Cycle lengthening 10–20%, DSO rising (collection slipping), or inventory building faster than sales
  • Red: Cycle lengthening 20%+, DPO stretching sharply (a sign of stretching suppliers to manage cash), or a working capital drain consuming all operating cash flow
  • Stretching payables while DSO rises is a classic liquidity-management distress pattern.

Domain 6 — Management & Organizational Instability

  • Evaluate leadership and organizational signals.
  • Amber: One C-suite or board departure in 12 months, a hiring freeze, or delayed/restated reporting
  • Red: CFO or CEO departure (especially abrupt), multiple senior exits, auditor change, going-concern language, or a pattern of missed forecasts
  • A CFO departing unexpectedly is one of the strongest qualitative distress signals there is.

Step 2: Compute the Composite Risk Rating

Convert domain statuses to a portfolio-level rating:

  • Low Risk: 0 Red, ≤1 Amber
  • Watch: 0 Red, 2–3 Amber
  • Elevated: 1 Red, or 4+ Amber
  • High Risk: 2 Red
  • Critical: 3+ Red, or any Red in Covenant Headroom combined with Red in Cash Conversion

Weight covenant headroom and cash conversion most heavily — these are the two domains where deterioration converts fastest into a liquidity event.

Step 3: Rank the Priority Flags

List the distress signals in order of urgency, not domain order. For each flag:

  • The specific metric and its current trajectory
  • Why it matters (the mechanism by which it becomes a crisis)
  • The likely time-to-impact (this quarter / 1–2 quarters / 6–12 months)
  • The single most important follow-up question to ask management

Step 4: Recommend Monitoring Cadence & Next Actions

Match intervention to the rating:

  • Low Risk / Watch: Quarterly review; name the 1–2 metrics to track most closely
  • Elevated: Monthly cash and covenant tracking; request a 13-week cash flow forecast
  • High Risk / Critical: Weekly liquidity tracking; recommend convening the board, engaging a turnaround advisor, or opening lender dialogue before a covenant breach forces the conversation
  • Always state the specific trigger that would escalate the rating.

Output Format

  • Structure: Executive summary with the composite rating up top, then a six-domain scorecard table, then ranked priority flags, then monitoring cadence and next actions
  • Length: 800–1,100 words
  • Format: Scorecard table for the six domains (Domain / Status / Key Metric / Trend / Note); prose for the summary, ranked bullets for flags
  • Sections: Composite Risk Rating → Six-Domain Scorecard → Ranked Priority Flags → Monitoring Cadence & Next Actions → Data Gaps & Confidence
  • Tone: Board-level and unhedged — the directness of a restructuring advisor who has seen distress arrive on schedule. State the rating plainly; do not bury the conclusion.

Quality Checklist

Before delivering output, verify:

  • [ ] All six domains are scored Green/Amber/Red with a stated metric and trend — none left blank
  • [ ] The composite rating follows the stated scoring rules and reflects the domain statuses
  • [ ] Priority flags are ranked by time-to-impact, not by domain order
  • [ ] Each Red flag includes a specific follow-up question for management
  • [ ] Monitoring cadence is matched to the rating, with an explicit escalation trigger
  • [ ] Data gaps are named and their effect on confidence is stated — no false precision on missing inputs

Notes

  • Trend beats level: a company with healthy absolute margins that are declining sharply is more at risk than one with thin but stable margins.
  • The two domains that convert fastest into a true crisis are covenant headroom and cash conversion — when both flash Red, treat it as Critical regardless of the other four.
  • Qualitative signals (CFO departure, auditor change, restated reporting) often lead the financial signals by a quarter or two; weight them seriously even when the numbers still look acceptable.
  • If management's narrative explicitly contradicts the metrics, flag the divergence — that gap is itself a distress signal.

How to use this skill

This file is a Claude Code skill in Anthropic's standard format — markdown with YAML frontmatter at the top.

Installing in Claude Code:

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Using in Claude.ai, ChatGPT, Gemini, or other AI tools:

  1. Drag this file into a new chat, or copy and paste its contents
  2. Send your task or request as your next message — the AI will apply the skill where it fits

For Claude Code skill details: https://docs.anthropic.com/en/docs/claude-code/skills