I´m confused about this - why couldn´t it also be "she understands it"? Does "o" only refer to "him"?
If it is being referred to a masculine word in Portuguese, you can use that. -"Vocé entende o livro? (Masc)" -"não, nâo O entendo"
Is this used for she understands him as a person and she understands what he's saying?
what is the difference between lhe and o in this sentence
It is a direct verb,then use "O/A" (http://www.learningportuguese.co.uk/language/object-pronouns.html)