The hadith means that everyone has the innate potential to become a Muslim. Meaning peace, salvation and obedience, Islam is, first of all, the natural religion of all creatures. Since everything in nature has been created to render absolute obedience to God and functions according to His laws, all creatures are Muslims. Considered from the viewpoint of their bodily structure, every human being and jinn, regardless of their religion, is muslim, since all bodies operate according to the laws determined for them by God. If a new-born could lead a completely isolated life free of environmental effects, he or she would remain a natural Muslim.
This hadith has another meaning: A new-born's mind is like a blank tape on which everything can be recorded. If he or she could be protected from any external effect that would bring about some impurity in his or her brain, such a person easily could receive anything related to Islam and become a perfect Muslim. But if the mind is made impure with many adverse elements, or if non-Islamic dogmas and traditions are fed into it, the person will become a follower of those religions or face great difficulties while trying to become a good Muslim.
Every new-born is like a seed to grow a good Muslim, for everyone comes to the world as the seed of a future Muslim. Adverse conditions cause this seed to be deformed or spoiled and, consequently, to become a follower of another religion or, according to the surrounding conditions, of no religion at all. Therefore, improving one's family and environmental conditions is vitally important if we want to produce good Muslims. After a child has reached the age of puberty, sins are a primary factor in deforming the seed. For this reason, it is said that every sin has the potential to guide the sinner to unbelief. So, we must do our best to protect ourselves against sins. Family, education, and environment are also of great importance for this purpose.