Why one changed letter marks the whole line
The comparison works line by line. Two lines are either the same or they are not, so correcting a single typo marks that entire line as rewritten. Inside a rewritten line the changed words are highlighted, which is usually enough to see what happened.
This matters most when a paragraph is one long line, as it is in a word processor. A three-hundred-word paragraph with one word changed shows up as one enormous rewritten line. If you are comparing prose, put a line break after each sentence in both versions first. The result becomes far easier to read, and the count of rewritten lines starts to mean something.
When to turn the two options on
Ignore capitalisation is for text that has been through a style pass. If someone changed every heading from title case to sentence case, every heading counts as rewritten and the real edits are buried. Switch it on and only the substantive changes remain.
Ignore spacing differences is for text that has moved between programs. Copying out of a PDF, pasting into an email client, or running code through a formatter all change indentation and collapse or add spaces without changing a word. With the option on, leading and trailing spaces are dropped and runs of spaces count as one.
Both options affect only the comparison. Whatever you pasted is what you see on screen, spacing and capitals intact.
Reading the percentage
The figure is the share of lines that appear unchanged in both versions. It answers “how much of this document did I leave alone”, which is useful when reviewing a returned draft or checking how heavily a translation memory match was edited.
It is not a plagiarism score. Two texts can share nothing line for line and still say the same thing in reordered sentences, and rewriting every line break drops the figure to zero without changing a word. Use it to gauge the size of an edit, not to make a judgement about authorship.
Checking a contract or a returned draft
The usual case is that someone sends back a version and does not say what they touched. Paste the version you sent on the left and the one you got back on the right, and every insertion, deletion and rewrite is listed in order.
Read the deletions with particular care. An added clause is visible in the document itself, but a removed obligation or a deleted deadline leaves nothing behind to notice, and this is the view where it shows.
Comparing code
Line endings are taken care of. A file saved on Windows ends its lines with CRLF and one saved on macOS or Linux with LF; both are read the same way here, so that difference alone never marks a line as changed.
Tabs and spaces behave the same way. A file converted from tabs to four spaces shows every line as rewritten until you ignore spacing.