The relationship between the way a word is spelled and the way that word is pronounced in English is reasonably predictable. Certain conventions, collectively known as the English cipher, loosely govern English spelling and pronunciation. To be able to decode words, children need an implicit understanding of those conventions.
The best test of the child's ability to sound out regular words is to ask her to name isolated (out of context) words that are not already familiar to the child. Using unfamiliar words insures that the child is deciphering them, and not just recognizing them or guessing based on contextual cues. Some tests simply use real, regular words that are so rare that it is unlikely that the words are familiar to the child (e.g. PUN, MOCK, LOOT), but some tests use invented or made-up words (called pseudowords) to insure that the child does not have any prior experience with the test items (e.g. PARD, ORT, SERT). Some tests attempt to make the task more authentic by asking the child to read aloud a list of people's names (to pretend they are "calling roll"). The names are spelled phonetically and are not difficult to pronounce -- they can range from very easy names for young children (e.g. JIM WILLS, STAN HILL, etc.) to somewhat more challenging for older children (e.g. WANDA BOLTON, VICTOR CONRAD, etc.).
For young readers who are not quite able to sound out regular words, it is appropriate to test their basic letter-sound knowledge (which is a precursor to regular word reading). Common letter-sound knowledge assessments ask a child to identify a letter that could represent a speech sound (e.g. Identify the letter that makes the /s/ sound.), or ask the child to generate a sound or several sounds that could be represented by a letter (e.g. What sound(s) do(es) the letter "S" make?). In some assessments of letter-sound knowledge, the letters are embedded in the context of words, and the child is asked to identify the first letter (or sometimes the vowel sound) of a spoken word.