If you noticed a drop in compression on one cylinder, and pouring a cap of oil through the spark plug holes didn't fix it, then it's likely you experienced a leaky valve or a burnt valve seat. What this test does is show you where it was leaking. Typically it takes a valve job to repair, but this can also occur on a freshly-machined head if any work was done improperly or out-of-center.
I'm using tap water for the test because both cylinder heads I'm testing will receive extensive machine work and cleaning before being re-used. If you were to do this test on a freshly-machined head, you'd want to use deionized water as it contains none of the salts (sodium, chlorine, etc...) that would leave deposits and corrode metal parts.