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Because "isst" is a singular form of the verb "essen".
Sie [capitalized] = you (formal)
sie [not capitalized] = she or they
As you said, since "sie" is the first word in this sentence, the fact that it's capitalized is inconclusive. But another important factor is always the verb - here, we have a singular form of the verb (3rd person singular), so it can only mean "she". For "you" and "they", a plural form of the verb would be used (3rd person plural).
Sie isst nicht. = She is not eating.
Sie essen nicht = They/You are not eating.
They are not eating/They do not eat = Sie essen nicht.
Standard German doesn't distinguish between the simple and the progressive aspects (eat vs. eating) - there is is just one form for both.
But the sentence in the exercise reads "Sie isst nicht", which means "She is not eating/She does not eat".
This thread became somewhat cluttered up, so I decided to clean it up a bit and delete a bunch of comments.
Quite a few people have asked about duolingo accepting "Sie ist nicht" as a correct solution. If it occurs in a listening exercise, it should be accepted since 'Sie isst' and 'Sie ist' sound exactly the same and are both grammatically correct. But note that the verb 'sein' normally isn't used on its own except for some religious or philosophical contexts. If it is accepted as a translation of 'She is not eating', this is clearly wrong and should be reported as an error.
Only by the spelling or the context - the pronunciation of "ist" and "isst" is identical.
Also, "Sie ist nicht" is an incomplete sentence in German. In anything other than a philosophical debate ("She thinks not, therefore she is not"), you would normally have to add some additional information about what she is not or where she is not.
I have heard learning German through Elizabethian english brings a great advantage the learner. :-) Interesting how "she does not" is still around colloquially.& she is not.... or is this a totally different concept I'm just blabering about? She is not the horse, she eats not the meal.
As a beginner, this is confusing and I think needs clarification. It says ´sie ist nicht´ which means she is not, however it is accepted as a translation of 'She is not eating', which is sie isst nicht, this is clearly wrong in this case and as I said confusing and should be reported as an error, I thought. The solution is, for beginners Duolingo would be better to only use words that sound the same in written form, so we can see the difference between the two and therefore and not just in audio...
Because that's not the correct answer. German sentence order is different so we don't translate it to another language in that exact order. You might talk like that with people around but that's not the correct way of talking among a huge majority of people, so it makes sense that "She eats not" is not the correct answer.