RAM Ratings (Lanka) said the sector has benefitted from falling interest rates which has increased margins due to deposit rates falling faster than rates on loans.
RFCs have taken steps to rein in bad debts which together with improving macroeconomic conditions will help improve asset quality, the rating agency said.
The sector is also recovering from a confidence crisis triggered by the fall of an unregulated finance company.
"RFCs showed an acceleration in loan growth across the industry, supported by the opportunities of the post-war era and the more favourable macroeconomic conditions," RAM Ratings said.
"The expansion in the loan base has resulted in the moderation of liquidity and capitalisation levels; however, these levels are adequate."
The rating agency said that while asset quality remains weaker than that of banks, as the sector caters to a high-risk segment, there has been increasing awareness among most RFCs to improve asset quality.
"Meanwhile, the sector has benefitted from the falling interest rate scenario that has increased margins due to deposits repricing faster than loans."
Lending by RFCs is generally long-term in nature at fixed interest rates, with hire-purchase and leases making up 64.73 percent of the industry's loan portfolio as at end-September 2010.
"The broader margins, coupled with loan expansion and lower provisioning charges, have resulted in improving performance," RAM Ratings said.
Asset quality is expected to improve in future as economic conditions improve further with the end of the 30-year ethnic war in 2009.
The improving profitability is expected to increase capitalisation levels of the RFCs which will also have more access to funds owing to compulsory listing on the Colombo stock exchange by June 2011.
"Meanwhile, the liquidity levels are expected to moderate but remain adequate as RFCs seek to expand their loan portfolios," the report said.
The RFC sector of 36 firms represents a small proportion of the Sri Lankan financial sector having 3.30 percent of the total assets of the financial system as at end-December 2009.