A Live CD is a bootable installation CD of Linux which lets you run Linux on your computer directly from the CD without having to partition your hard drive for a Linux installation. Like the main installations of Linux, Live CDs of most of the Linux distributions also include many applications and work the same way as they do in a permanent installation. A Live CD typically doesn’t alter the operating system files on your computer or your hard drive partitions and restores your computer to its previous state once the computer is rebooted after ejecting the Live CD.
A Live CD works by storing the files required by the operating system (that would typically be stored in a hard drive in a normal installation) in RAM. This is done by using a "RAM Disk" which can be loosely defined as a technique to use the RAM to store files as if they were actually on the hard drive.
Although the first Live CD was introduced by Yggdrasil Linux (which is no longer in development), Knoppix was the company that popularized the concept of a Live CD years later. Since its first release Knoppix has found wide use primarily as a rescue disk system. In recent times, Ubuntu Live CD has grown to become another popular Live CD option. (You can find a huge list of Live CDs here.)
The most common use of a Live CD is to try out a Linux distro before installing it permanently on your hard drive. There may be various reasons to do it. For example, using it to determine if your hardware is compatible with the Linux distro before trying to install it is a common and sensible use. Another would be for a new user of Linux to use one to become familiar with Linux and the particular distro before installing. They can also be helpful in deciding if KDE or Gnome, which are two popular and competing desktop environments available for many distributions, is preferred.
Whatever the reason, a Live CD provides you with a great opportunity to try out Linux before installing it. Diagnosing your system in case of any system problem is another area where a Live CD can help. A Live CD can be extremely useful in dealing with a critical issue which renders the system unbootable, or for removing a virus or other malware. It can be useful when you need to use Linux on any system which doesn’t have Linux installed on it. It can also be used to test various things about your computer like hardware compatibility and network security.
By now you should have a fair idea of what a Live CD is and what it does. Although using Linux from a Live CD results in some performance drag (as it is run from a CD/DVD drive and reduces the amount of RAM available for applications considerably because of the use of a RAM drive) it still offers many benefits over a permanent Linux installation for specific situations. It cannot be a replacement for a permanent installation if you are going to be using Linux everyday on your system for your daily tasks, but at the same time it offers a great way for a newcomer to Linux to get familiar with it before installing it onto his hard drive. That’s the reason it is often compared to a test drive: a Live CD is a test drive of the Linux distro before you make up your mind to install or not install it.