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But how do you edit a race or creat one from scratch? Is this something you can do inside the game or do you have to do this outside of the game by like editing text files?
If you want the computer to play a custom created AI empire, then, yes, you will have to do some editing of text files outside the game.
But if you just want to create a custom race to play yourself, you can do this inside the game. Click on Add New, and the game will let you choose your emperor title and shipset from those for other AI races. Then, you can edit this player to customize stuff like home planet type (rock/ice/gas giant), atmosphere, and you can pick your own culture, racial points and advanced traits. When you have created one you like, you can even save it and use it again later.