<PAGE>   1
                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                   FORM 10-Q

(Mark One)

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
     For the quarterly period ended:  SEPTEMBER 30, 1996

                                       OR

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934
     For  the transition period from ____________ to ____________

                        Commission file number:  0-20679


                           MECHANICAL DYNAMICS, INC.
             (Exact name of registrant as specified in its charter)


                                              
               MICHIGAN                                      38-2163045
     (State or other jurisdiction of
     incorporation or organization)         (I.R.S. Employer Identification No.)

                            2301 COMMONWEALTH BLVD.
                           ANN ARBOR, MICHIGAN  48105
                                 (313) 994-3800
                    (Address of principal executive offices,
                       including zip code, and telephone
                          number, including area code)


     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                               [X]  Yes       [  ]  No



     Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.


         NO PAR VALUE                                    5,743,222
    (Class of common stock)               (Outstanding as of November 8, 1996)


<PAGE>   2


                           MECHANICAL DYNAMICS, INC.

                                     INDEX


                                                                        Page No.
PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS


         Condensed Consolidated Balance Sheets as of                        3
            September 30, 1996 and December 31, 1995                        
                                      
         Condensed Consolidated Statements of Income                        4
            for the Three and Nine Months Ended 
            September 30, 1996 and 1995

         Condensed Consolidated Statements of Cash Flows                    5
            for the Nine Months Ended September 30, 1996 and 1995  
            
         Notes to Condensed Consolidated Financial Statements               6

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION        7
         AND RESULTS OF OPERATIONS                                          


PART II. OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K                                  11


SIGNATURES                                                                 12


INDEX TO EXHIBITS                                                          13


                                       2

<PAGE>   3
PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

     

<TABLE>
<CAPTION>
                                                   September 30,  December 31,
                                                       1996         1995
===============================================================================
                                                   (unaudited) 
                                                      
<S>                                                  <C>          <C>
Assets:                                               
Current assets:                                       
  Cash and cash equivalents                           $20,778      $1,141
  Accounts receivable                                   4,490       4,423
  Prepaid and deferred expenses                           902         936 
--------------------------------------------------------------------------------
     Total current assets                              26,170       6,500
                                                      
Net property and equipment                              1,413       1,268 
Total other assets                                      1,532       1,570 
--------------------------------------------------------------------------------
Total assets                                          $29,115      $9,338
================================================================================
                                                      
Liabilities And Shareholders' Equity:                 
Current liabilities:                                  
  Borrowings under lines of credit                        $38         $82 
  Accounts payable                                        443         620 
  Accrued expenses                                      3,351       2,777
  Deferred revenue                                      3,574       3,666
--------------------------------------------------------------------------------
     Total current liabilities                          7,406       7,145
--------------------------------------------------------------------------------
                                                      
Redeemable common stock                                   167         859
                                                      
Shareholders' equity:                                 
  Convertible preferred stock                               0         265 
  Common stock                                         19,380           9
  Common stock warrants                                     0         449 
  Additional paid-in capital                                0         114 
  Retained earnings                                     2,120         475 
  Subscriptions receivable                                  0         (10)
  Cumulative translation adjustment                        42          32
--------------------------------------------------------------------------------
     Total shareholders' equity                        21,542       1,334 
--------------------------------------------------------------------------------
Total liabilities and shareholders' equity            $29,115      $9,338  
================================================================================

</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.


                                      3
<PAGE>   4
                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                  CONDENSED CONSOLIDATED STATEMENTS OF INCOME
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                  (UNAUDITED)

<TABLE>
<CAPTION>                                                                           
                                          Three Months Ended     Nine Months Ended      
                                             September 30,          September 30,          
-------------------------------------------------------------------------------------
                                          1996       1995        1996       1995     
=====================================================================================
<S>                                        <C>       <C>        <C>          <C>     
Revenue:                                                                             
  Software licenses                        $3,592     $2,992     $11,111     $9,006  
  Services                                  3,071      2,332       7,841      6,251  
-------------------------------------------------------------------------------------
    Total revenue                           6,663      5,324      18,952     15,257  
-------------------------------------------------------------------------------------
Cost of revenue:                                                                     
  Software licenses                           114        115         472        524  
  Services                                  1,733      1,189       4,426      3,675  
-------------------------------------------------------------------------------------
    Total cost of revenue                   1,847      1,304       4,898      4,199  
-------------------------------------------------------------------------------------
Gross profit                                4,816      4,020      14,054     11,058  
-------------------------------------------------------------------------------------
Operating expenses:                                                                  
  Sales and marketing                       2,450      2,137       7,247      5,886  
  Research and development                    871        719       2,626      2,144  
  General and administrative                  683        696       2,052      1,917  
-------------------------------------------------------------------------------------
    Total operating expenses                4,004      3,552      11,925      9,947  
-------------------------------------------------------------------------------------
Operating income                              812        468       2,129      1,111  
                                                                                     
Other income (expense), net                   235        (30)        311        (14) 
-------------------------------------------------------------------------------------
Income before income taxes                  1,047        438       2,440      1,097  
                                                                                     
Provision for income taxes                    334         77         795        193  
-------------------------------------------------------------------------------------
Net income                                   $713       $361      $1,645       $904  
=====================================================================================
                                                                                     
Calculation Of Net Income Per Share:                                                 
Net income                                   $713       $361      $1,645       $904  
  Accretion of warrants                         0         58           0        168  
-------------------------------------------------------------------------------------
Net income available to common shareholders  $713       $303      $1,645       $736  
=====================================================================================
Net income per common share                 $0.12      $0.08       $0.34      $0.19  
=====================================================================================
Common and common equivalent shares         5,862      3,853       4,809      3,840  
=====================================================================================
</TABLE>   


The accompanying notes are an integral part of these condensed consolidated
financial statements.


                                      4
<PAGE>   5
                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                            Nine Months
                                                                        Ended September 30,          
---------------------------------------------------------------------------------------------
                                                                       1996             1995
---------------------------------------------------------------------------------------------
<S>                                                                 <C>             <C>
Cash flows from operating activities:                                                                          
  Net income                                                          $1,645             $904
  Adjustments to reconcile net income to net cash                              
   provided by operating activities:                                            
    Depreciation and amortization                                        410              456
    Provision (credit) for deferred income taxes                         (65)             (72)
    (Gain) loss on disposal of assets, net                                11                0
    Changes in assets and liabilities:                                         
      Accounts receivable                                                (38)            (383)
      Prepaid and deferred expenses                                       36             (149)
      Other assets                                                        35               52
      Accounts payable                                                  (204)            (318)
      Accrued expenses                                                   570              798
      Deferred revenue                                                  (108)             750
---------------------------------------------------------------------------------------------                               
         Net cash provided by operating activities                     2,292            2,038
---------------------------------------------------------------------------------------------                               
      
Cash flows from investing activities:
  Proceeds from the sale of property and equipment                         0               54
  Purchases of property and equipment                                   (494)            (663)
---------------------------------------------------------------------------------------------
         Net cash used in investing activities                          (494)            (609)
---------------------------------------------------------------------------------------------
  
Cash flows from financing activities:
  Net borrowings (payments) under line of credit agreements              (44)            (685)
  Proceeds from the issuance of common stock                          17,850               18
  Proceeds from collections on subscriptions receivable                   10               18
  Payments of long-term debt                                               0             (456)
---------------------------------------------------------------------------------------------
         Net cash provided by (used in) financing activities          17,816           (1,105)
---------------------------------------------------------------------------------------------
  
Effect of exchange rate changes on cash                                   23                5
---------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents                             19,637              329
Cash and cash equivalents at beginning of period                       1,141              817
---------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period                           $20,778           $1,146
=============================================================================================

Supplemental disclosures of cash flow information:
  Cash paid during the year for:                              
    Interest                                                             $18              $51
    Income taxes                                                        $444             $290
=============================================================================================
</TABLE>

The accompanying notes are an integral part of these condensed consolidated
financial statements.

                                      5
<PAGE>   6


                   MECHANICAL DYNAMICS, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


NOTE (1) - BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements include
the accounts of Mechanical Dynamics, Inc. ("MDI" or the "Company") and its
subsidiaries, and have been prepared in accordance with generally accepted
accounting principles for interim financial information and with Article 10 of
Regulation S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.  The Company believes all adjustments, consisting of
normal recurring adjustments considered necessary for a fair presentation, have
been included. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Company's Registration
Statement on Form S-1 for the year ended December 31, 1995.

Operating results for the three- and nine-month periods ended September 30, 1996
are not necessarily indicative of the results that may be expected for the year
ended December 31, 1996.


NOTE (2) - REDEEMABLE COMMON STOCK AND SHAREHOLDERS' EQUITY

In July 1996, the redemption privileges associated with 20,842 shares of
redeemable common stock expired. The redemption privileges on the remaining
20,843 shares of redeemable common stock outstanding are exercisable at $8.00
per share between June 15, 1997 and July 14, 1997.

                                       6

<PAGE>   7


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

The following information should be read in conjunction with the condensed
consolidated financial statements and the notes thereto included in Item 1 of
this Quarterly Report  and with Management's Discussion and Analysis of
Financial Condition  and Results of Operations contained in the Company's
Prospectus dated May 14, 1996 and filed with the Securities and Exchange
Commission.

OVERVIEW

Mechanical Dynamics develops, markets and supports virtual prototyping
solutions.  The Company's virtual prototyping software allows the engineer or
designer to design a complete product by simulating, both visually and
mathematically, a product in motion.  The Company's principal software product,
ADAMS Full Simulation Package, is used by customers to simulate mechanical
systems.  The Company's revenue has in the past been, and is expected in the
future to be, derived almost exclusively from its ADAMS Full Simulation Package
and related software products and services.

FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY

Except for the historical information contained in this Quarterly Report, the
matters herein contain "forward-looking" statements (as defined in the Private
Securities Litigation Reform Act of 1995) that involve risk and uncertainty.
These forward-looking statements include, but are not limited to, revenue
levels, including the level of international revenue, certain costs and
operating expense levels, the level of other income, the Company's liquidity
and capital needs and various business environment and trend information.
Actual future results and trends may differ materially depending on a variety of
factors, including the volume and timing of orders received during the quarter,
the mix of and changes in distribution channels through which the Company's
products are sold, the timing and acceptance of new products and product
enhancements by the Company or its competitors, changes in pricing, the level
of the Company's sales of third party products, purchasing patterns of
distributors and customers, competitive conditions in the industry, business
cycles affecting the markets in which the Company's products are sold,
extraordinary events, such as litigation or acquisitions, including related
charges, and economic conditions generally or in various geographic areas. All
of the foregoing factors are difficult to forecast.  The future operating
results of the Company may fluctuate as a result of these and other risk
factors detailed in the Company's Prospectus dated May 14, 1996 and filed with
the Securities and Exchange Commission.

Due to all of the foregoing factors, the Company believes that period-to-period
comparisons of its results of operations are not necessarily meaningful and
should not be relied upon as an indication of future performance. It is likely
that, in some future quarters, the Company's operating results will be below
the expectations of stock market analysts and investors. In such an event, the
price of the Company's Common Stock would likely be materially adversely
affected.

RESULTS OF OPERATIONS

Revenue

Revenue increased 25.2% from $5.3 million in the third quarter of fiscal 1995
to $6.7 million in the third quarter of fiscal 1996. Revenue increased 24.2%
from $15.3 million in the first nine months of fiscal 1995 to $19.0 million in
the first nine months of fiscal 1996. The increase in revenue was due to growth
in both software licenses revenue and services revenue.  As a percentage of the
Company's revenue, software licenses revenue declined from 56.2% in the third
quarter of fiscal 1995 to 53.9% in the third quarter  of fiscal 1996, and from
59.0% in the first nine months of fiscal 1995 to 58.6% in the first nine months
of fiscal 1996. Conversely, services revenue increased as a percentage of
revenue from 43.8% in the third quarter of fiscal 1995 to 46.1% in the third
quarter  of fiscal 1996, and from 41.0% in the first nine months of fiscal 1995
to 41.4% in the first nine months of fiscal 1996. The increased proportion of
services revenue was primarily related to an increase in services performed for
the Company's ADAMS/Car customers.


                                       7

<PAGE>   8


The percentage of the Company's revenue from international customers was 57.3%
and 59.0% for the third quarter of fiscal 1995 and 1996, respectively.  The
percentage of revenue from customers located internationally was 60.7% and
61.1% for the first nine months of fiscal 1995 and 1996, respectively.  The
Company expects that international revenue will continue to be a major
component of the Company's total revenue in the future.

Software licenses revenue increased 20.1% from $3.0 million in the third
quarter of fiscal 1995 to $3.6 million in the third quarter of fiscal 1996.
Software licenses increased 23.4% from $9.0 million in the first nine months of
fiscal 1995 to $11.1 million in the first nine months of fiscal 1996.  The
increases in software licenses revenue resulted from further market penetration
of the Company's products, highlighted by sales to new customers as well as
additional sales into the Company's existing customer base.  Furthermore,
customer order size has increased, with  more customers  purchasing certain of
the Company's modular packages along with their purchase of the ADAMS Full
Simulation Package. Software license revenue declined by $86,000 from the
second quarter of fiscal 1996 to the third quarter of fiscal 1996.  This
decline, primarily due to a decline in the software licenses revenue from
Europe in the third quarter, reflects a seasonal pattern which the Company has
experienced in prior years.

Services revenue consists of revenue from software maintenance agreements as
well as consulting, training  and funded research and development. Services
revenue increased 31.7% from $2.3 million in the third quarter of fiscal 1995
to $3.1 million in the third quarter of fiscal 1996. Services revenue increased
25.4% from $6.3 million in the first nine months of fiscal 1995 to $7.8 million
in the first nine months of fiscal 1996. Revenue from software maintenance
agreements increased by 15.3% for the third quarter of fiscal 1996, versus the
similar period in 1995, and by 21.3% for the first nine months of fiscal 1996,
versus the similar period in 1995. These increases were primarily due to the
growth in the Company's installed base of customers as well as the strong level
of repeat business the Company has experienced through customers renewing their
existing software maintenance agreements. The Company expects the majority of
customers currently under software maintenance agreements to renew their
agreements in the future. Revenues from consulting, training and funded
research and development services increased by 42.6% for the third quarter of
fiscal 1996 versus the similar period in 1995, and by 28.2% for the first nine
months of fiscal 1996 versus the similar period in 1995.  These increases were
primarily the result of customers continuing to embed the Company's products
and services directly into their product design processes.

Cost of Revenue

The cost of software licenses revenue as a percentage of software licenses
revenue decreased from 3.8% to 3.2% for the third quarters of fiscal 1995 and
1996, respectively.  The cost of software licenses revenue decreased from 5.8%
to 4.2% for the first nine months of fiscal 1995 and 1996, respectively.  These
decreases were primarily due to a reduction in royalties paid to third parties
whose software products were licensed through the Company's European
subsidiaries.

The cost of services revenue as a percentage of services revenue increased from
51.0% to 56.4% for the third quarters of fiscal 1995 and 1996, respectively.
The cost of services revenue decreased from 58.8% to 56.4% for the first nine
months of fiscal 1995 and 1996, respectively.  The increase in the third
quarter of 1996 was primarily due to a shift in services revenue mix from the
higher margin software maintenance revenue to consulting, training, and funded
research and development revenue. Conversely, the decrease in the cost of
services revenue as a percentage of services revenue for the first nine months
of fiscal 1996 versus 1995 was primarily due to the year-to-date growth in
revenues generated by the higher margin software maintenance component.

Operating Expenses

Sales and marketing expenses were $2.1 million and $2.5 million for the third
quarter of fiscal 1995 and 1996, respectively, representing 40.1% and 36.8% of
total revenue for the respective periods. Sales and marketing expenses were
$5.9 million and $7.2 million for the first nine months of fiscal 1995 and
1996, respectively, representing 38.6% and 38.2% of total revenue for the
respective periods.  The percentage decreases were primarily due to a decrease
in commissions paid to third party sellers, coinciding with a lower proportion
of software licenses revenue recognized from this sales channel.  In addition,
the absolute dollar increases in sales and marketing expenses were primarily
due to incremental marketing and sales expenses incurred in Japan, and in
connection with the opening of new sales offices during the last twelve months
in Ohio, Texas, New Jersey, Germany, and Italy. The 


                                      8

<PAGE>   9

Company expects to continue the growth of its worldwide sales and marketing 
organization in the future, reflecting the Company's commitment to expand its 
global market penetration.

Research and development expenses were $719,000 and $871,000 for the third
quarter of fiscal 1995 and 1996, respectively, representing  13.5% and 13.1% of
total revenue for the respective periods. Research and development expenses
were $2.1 million and $2.6 million for the first nine months of fiscal 1995 and
1996, respectively, representing  14.1% and 13.9% of total revenue for the
respective periods. The increases in research and development expenses were
primarily the result of additional personnel hired to support development of
new products as well as the enhancement of existing products. The Company
intends to continue to invest significant resources in research and development
activities during future periods.

General and administrative expenses were $696,000 and $683,000 for the third
quarter of fiscal 1995 and 1996, respectively, representing  13.1% and 10.3% of
total revenue for the respective periods. General and administrative expenses
were $1.9 million and $2.1 million for the first nine months of fiscal 1995 and
1996, respectively, representing  12.6% and 10.8% of total revenue for the
respective periods. The increase in general and administrative expenses for the
first nine months of fiscal 1996 was primarily due to increased expenses
associated with managing the Company's growing operations worldwide.

Other Income (Expense), Net

Other income (expense), net amounted to $30,000 in expense and $235,000 in
income for the three months ended September 30, 1995 and 1996, respectively.
Other income (expense), net amounted to $14,000 in expense and $311,000 in
income for the first nine months of fiscal 1995 and 1996, respectively.  The
increases were primarily the result of interest earned on the proceeds from the
Company's initial public offering on May 15, 1996, partially offset by foreign
currency transaction losses incurred during 1996.

Provision For Income Taxes

The Company's effective tax rate was 17.6% and 32.6% for the first nine months
of fiscal 1995 and 1996, respectively. The difference between the effective and
statutory federal rate in 1996 was due primarily to the benefit of tax exempt
interest income and certain tax credits recognized in 1996.

LIQUIDITY AND CAPITAL RESOURCES

The Company has funded its operations to date primarily through internally
generated cash flow. Cash and cash equivalents increased by $19.7 million from
$1.1 million as of  December 31, 1995 to $20.8 million as of September 30,
1996. The increase was primarily the result of the $17.8 million in net
proceeds raised from the Company's initial public offering in May 1996, and, to
a lesser extent, cash flow generated from operations.

In April 1996, the Company entered into an agreement with its principal bank for
a $2.0 million line of credit. The agreement is subject to annual renewal, and
expires on April 30, 1997. Borrowings on the line of credit bear interest at the
bank's prime rate. In September 1996, the Company's Business Loan Note issued in
connection with the April 1996 agreement with it's principal bank was amended to
release the bank's security interest in the Company's accounts receivable. No
borrowings were outstanding under this agreement as of September 30, 1996. The
Company's subsidiaries in Germany, Italy, Sweden, and France also have line of
credit and overdraft facilities that provide for aggregate borrowing
availability of approximately $600,000.

Long term cash requirements, other than for normal operating expenses, are
anticipated for the development of new software products and enhancements of
existing products, financing growth, and the possible acquisition of software
products, technologies and businesses complementary to the Company's business.
The Company believes that cash flows from operations, together with existing
cash balances, and available borrowings will be adequate to meet the Company's
cash requirements for working capital and capital expenditures for the next
twelve months and the foreseeable future.

Net cash provided by operating activities increased by $254,000 from $2.0
million in the first nine months of fiscal 1995 to $2.3 million in the first
nine months of fiscal 1996. The increase was mainly due to higher net income
and 

                                       9

<PAGE>   10


changes in accounts receivable, deferred revenue and accrued expenses
during the nine month period in 1996 versus the similar period in 1995.

Net cash used in investing activities decreased by $115,000 from $609,000 in
the first nine months of fiscal 1995 to $494,000 in the first nine months of
fiscal 1996.  The decrease was primarily due to reduced purchases of property
and equipment during the comparable period in 1996.

Net cash provided by financing activities increased by $18.9 million from $1.1
million of cash used in financing activities during the first nine months of
fiscal 1995 to $17.8 million of cash provided by financing activities during
the first nine months of fiscal 1996. The increase was primarily due to the net
proceeds of $17.8 million raised in the Company's initial public offering in
May 1996. Also, to a lesser extent, the increase was due to a $1.1 million
reduction of cash used for debt payments during the nine month period in 1996
versus the similar period in 1995.


                                       10

<PAGE>   11


PART II.  OTHER INFORMATION

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K


(a) EXHIBITS


Number                        Exhibit
------                        -------
(4.2)   Amendment To Note between KeyBank National Association and the Company
        dated September 25, 1996

(11)    Computation Of Earnings Per Share

(27)    Financial Data Schedule

(b) REPORTS ON FROM 8-K

No reports on Form 8-K were filed by the Company during the three months ended
September 30, 1996.


                                     11

<PAGE>   12


SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.





Dated: November 14, 1996          MECHANICAL DYNAMICS, INC.
                                  (Registrant)



                                  /s/ James E. Vincke
                                  ----------------------------------------------
                                  JAMES E. VINCKE
                                  Vice President of Finance & Administration and
                                  Chief Financial Officer
                                  (a duly authorized officer and Principal 
                                  Financial Officer)






                                     12


<PAGE>   13

INDEX TO EXHIBITS



Number                               Exhibit Title
------                               -------------
(4.2)   Amendment To Note between KeyBank National Association and the Company
        dated September 25, 1996

 (11)   Computation Of Earnings Per Share

 (27)   Financial Data Schedule


                                       13