Learn Finnish: Mitä kuuluu, ystävä?

This is a fixed greeting in Finnish. The verb kuulua literally means "to be heard," so the phrase originally translates to something like "What is heard?" or "What is the news?".

How do I answer this question?

Because the question uses the partitive word mitä, your answer is usually in the partitive case too. The most common reply is Hyvää (Good) or Hyvää, kiitos (Good, thank you).

Why is the word ystävä in its basic dictionary form here?

When you are addressing someone directly, like calling out "friend" or using their name, Finnish just uses the basic dictionary form (the nominative case).

Can I translate "How are you" word-for-word and say Miten sinä olet?

No, that will sound very strange to a Finnish speaker. To ask how someone is doing, you must use fixed phrases like Mitä kuuluu or Miten menee (How is it going).