We look at how firms conduct external financing policies under financing constraints. Rather than focusing on leverage ratios to understand debt and equity issuance decisions, we look at the substitution effect between internal and external financing in the firm's investment optimization problem. In the absence of capital market frictions, firms are able to find financing for all positive NPV projects. In this case, there exists a strong negative relation between operating cash flows and the demand for new external financing when firms prefer using internal funds to invest. When firms face costly access to external funds, however, the optimal, endogenous response of investment to income shocks causes the external-internal funding substitution effect to be strictly weaker (or even disappear). We use data from US firms over the 1971-2001 period to test these predictions. Our tests show that the sensitivity of external financing to cash flow innovations is negative and significant for firms typically regarded as financially unconstrained (those that distribute large amounts of cash dividends, are large in size, and whose bonds and commercial papers are rated). In contrast, external-internal financing sensitivities are insignificant for constrained firms. Importantly, our results indicate that these patterns hold separately for both debt and equity financing. We also find that differences in external-internal financing sensitivities across constrained and unconstrained firms are magnified in the aftermath of macroeconomic movements that tighten financial constraints, such as economic downturns. Our evidence suggests that investment funding constraints have first-order cross-sectional and inter-temporal effects on firm financing decisions, effects that have been overlooked by the capital structure literature.