You can't judge a return without knowing the risk — or read a company without its statements.
What you will learn
Explain the risk-return tradeoff
Read the three financial statements
Compute key ratios from the statements
Risk vs return
Risk vs return
The efficient frontier
The efficient frontier
Risk and return are two sides of one coin
Higher expected return is compensation for higher risk — not a free lunch. The question isn't 'how much can I make?' but 'how much can I lose, and am I being paid enough to accept that?' Risk is the possibility your actual return differs from expected.
Types of risk
Systematic risk (market risk) affects everything — recessions, rate shocks — and can't be diversified away. Unsystematic risk (a single company's failure) can be diversified away by holding many assets. Diversification eliminates specific risk for free; market risk remains.
The three statements
The income statement shows revenue, costs, and profit over a period. The balance sheet is a snapshot of assets, liabilities, and equity at a point in time. The cash flow statement tracks actual cash in and out. Profit ≠ cash — that's why all three matter.
💡 Profit vs cash
A company can show big profits while running out of cash (selling on credit, building inventory). The cash flow statement reveals the truth: cash from operations is the lifeblood. Many profitable companies have died from a cash crunch.
Key ratios
P/E (price ÷ earnings) shows what you pay per dollar of profit. Debt/equity shows leverage. ROE (net income ÷ equity) shows how efficiently the company uses shareholder capital. Current ratio (assets ÷ liabilities) shows short-term solvency. Ratios only mean something in comparison.
💡 Reading a P/E
A P/E of 40 means investors pay $40 for $1 of today's earnings — betting on future growth. A P/E of 8 means the market is skeptical or the company is mature. Neither is 'good' in isolation; both must be read against growth, peers, and the market's own multiple.
❓ Quick check
Which risk can be eliminated by diversification?
A) Market risk
B) Company-specific (unsystematic) risk
C) Inflation risk
D) Interest-rate risk
Diversification removes idiosyncratic risk, not market risk.
(Knowledge check — full exam is next)
Key takeaways
Return is compensation for risk, never free
Diversification kills specific risk; market risk remains
Profit ≠ cash — read all three statements plus ratios
📝 Weekly Exam — pass with 80% to unlock next week
10 questions. Review the Deep Dive and courses before attempting.
1. Higher expected return is:
Return is payment for bearing risk.
2. Market (systematic) risk:
Systematic risk is economy-wide.
3. Diversification eliminates:
Specific/idiosyncratic risk diversifies away.
4. The income statement shows:
Profit & loss over time.
5. The balance sheet is:
Point-in-time financial position.
6. Why does profit ≠ cash?
Accrual accounting decouples profit from cash.
7. P/E ratio is:
Price-to-earnings = what you pay per $1 of profit.
8. A high P/E typically signals:
High multiple = growth priced in.
9. ROE measures:
Return on equity.
10. Cash from operations is important because:
Operating cash flow reveals true health.
Your score: —
🛠 Weekly Project
Pull one public company's statements and compute two ratios.
1
Pick a public company and find its income statement and balance sheet.
2
Compute P/E and debt/equity.
3
Compare both to one peer company.
4
Write 2 sentences on which looks cheaper/safer and why.