Sight reading is the act of reading and playing a piece of music before having ever seen it: on sight. This technique is a vital one for musicians to learn. Being skilled in sight reading makes reading a piece of music easier; the musician doesn't have to labor over every note and re-teach themselves the common patterns. Sight reading, after a decent amount of practice, becomes like second nature.
A solid knowledge of music theory is absolutely crucial to a musician who wants to become proficient in sight reading. Besides acting as the basis for understanding the notes, a music theory education provides the ability to see patterns within the piece of music, a large part of the sight reading puzzle. Sight reading, after all, doesn't require the musician to read every single note. Most musicians rarely see the entire piece of music, but rather the patterns that emerge from it. They understand notes and how they function in relation to each other and are therefore able to deduce most of the chords and changes -- all from just glancing at the basic structure of the piece.
For example, musicians who know music theory will first determine the key of the song from the key signature, which in turn gives them strong hints about which chords will probably be used most in the song. This knowledge alone enables the sight reader to be mentally prepared when those chords occur, and to be alert for chords which are unexpected.
They will also be aware of intervals such as 3rd and 6ths and 7ths, and they will look for the form of the song - ABA, AABA, ABACA, or whatever. They will be aware of the probably rhythm patterns based on the time signture, and they will quickly scan the score for repeats, tempo signs, volume changes, and so on.
In fact, most sight reading mistakes typically happen when a piece of music takes an unexpected turn, deviates from the common pattern. These mistakes, however, are few and far between with those proficient in sight reading. An experienced sight reader will have learned to not only see patterns but also to read ahead in a piece of music while they are playing it. Looking several bars ahead to catch anything tricky or unexpected is often done while holding a sustain or resting.
Sight reading plays a large role in music education, and students are frequently tested on their ability to do it well. Some sight reading exams will allow the student a few minutes to look over the piece and prepare; he or she will be able to make notes, mark up tricky time signatures or changes. Tempo is rarely a consideration in these sight reading exams as playing the piece well is far more important than playing the piece up to speed.
Advanced sight reading exams, however, aren't quite as forgiving. These exams give the student minimal, if any, time to prepare, and tempo is absolutely considered into the final grade. Advanced sight reading exams prepare a student for work as a studio musician, a career where near-perfect sight reading is a must. The majority of studio musicians record a piece of music after only seeing it once -- sometimes not at all. A flawed skill in sight reading will only prove to be a hindrance to the working musician; it is for that reason considered one of the most important parts of a music theory education.
This does not mean, of course, that a musicians can't reach the top rungs without good sight-reading skills. After all, many top jazz pianists don't read music at all, but are gifted with incredible ears and improvisational skills. But for most of us it is a helpful skill to develop to the best of our ability.