Basicly remembers all of the graphics and xml files, so when you load up FM next time it loads instantly instead of searching for and loading all the xml files. When I say instantly I mean with skin cache on when you double click the FM shortcut to load the game it loads instantly (well after its done the copy protection cd check)you get the green Sega/SI screen quickly.
With skin cache off it can take a couple of minutes for the first green/black screen to appear after double clicking the FM shortcut. (Which in FM2005 caused inpatient people to moan that the game doesn't work - which is probarbly the main reason why they made the cache).
The downside is that with the skin cache on, the game doesn't detect any new xml files or changes since the cache was built.
Deleting the contents of the cache folder is the easiest way to clear the cache. (So you can leave the skin cache option on amd just delete the cache folder when you install new/change graphics.)
The Skin cache is also explained in the manual (not that anyone bothers to read it

).
NOTE: The cache file DOESN'T contain the graphics, don't delete the actual graphics or config files, they are still needed for the graphics to show.